Hedge This Bear Market Rally with TLT

Summary:

Prices in the US 30-Year Treasury collapsed significantly enough and relatively large against the shorter-term government debt securities. Both the 3-month rally and the dumping of the US currency are strong reasons to place a long position with TLT. Note that TLT is on the kaChing insight page and is listed as a 77th recommendation as a SHORT. This recommendation is therefore a contrarian position against the kaChing user community (a virtual portfolio manager site with over 350,000 users worldwide).

Note: When I refer to TLT, I will be referring to the underlying 30-year Treasury bond.

Top-Down Analysis:

When the government announced that it was going to essentially print money to pay for its own debt, 30-year treasuries corrected slightly. During that time, it was revealed that China was reducing its holdings in USD currency and began/continued to accumulate commodities. It may be a political move to make the statement that China will not tolerate the increasing debt load of the US (thereby depreciating the value of US-denominated assets). There is too much speculation required to decipher China/US dynamics, so let me get to the kicker:

Investors need to note the momentum shift that occurred in the last two weeks between the 2- 5-, and 10-year bonds versus the 30-year bonds. Rates rose significantly for the shorter-term debts as compared to the 30-year. The impact to the economic policy is significant: The Fed does not have the control we all assumed was there in controlling interest rates.

Banks limited the mortgage renewal terms, especially for the longer-term ones.

So what? Why should US debt prices move up from here?

Remember that when the markets were in free-fall, TLT was in a state of a “mini-bubble. Since it has sold off and is at ~ $90, what is needed for TLT to rise again are the following:

1) Flow of assets out of commodities (gold, copper, silver) and into a currency (U.S. dollar).

*** Comments: See point #3 about China. The problem I see about gold as a “safe haven” against the US dollar is that a country will still need to convert the holding to some currency before spending it. What currency will it use?

What currency is strongest relative to every other currency?

It is certainly not the Euro (London, Spain, Eastern Europe is far weaker than that of the U.S.).

Canadian dollar? It’s too dependent on resources.

Counter-argument: yuan or yen? Maybe.

2) Stock market correction and investors seeking for “safety.”

*** Comments: The stock market rallied almost 40% in just 3 months. True, stocks were undervalued and the bank crisis was a crisis until it was “fixed.” But now we need to get in the mind of the herd. The herd is thinking “profit taking.” As such, we need to get ahead of the curve and accumulate “safety.”

3) Realization that inflation does not exist

*** Comments: Oil has risen 80%. Ditto for gold and silver. This is all because of markets thinking “the worst is behind us,” and therefore we should immediately expect some kind of major inflation. You know what? This is not going to happen. “Bailout” funds have all be diverted to the banks and little of it has actually reached the economy. Even the housing bailout reaching out to consumers barely impacts more than 55,000 or so homeowners.

Counter-argument: If China is accumulating commodities because long-term demand for it exists, then this argument will be weakened.

Some Relative Figures:

As of June 3 2009 (versus last month)

• 2-year - 0.91%
• 5-year - 2.42% vs 2.02%
• 10-year - 3.54% vs 3.73%
• 30-year - 4.44% vs 4.05%

Analysis:

Treasury offering tomorrow may pressure TLT. Use this as a buying opportunity.

More Reading and Additional Thoughts:

Here is a great summary posted by another blog:

"Regardless why the yield curve is steepening, Bernanke's belief that he can control both the long and short end of the curve is seriously misguided. The fact is he cannot really control either, at least for long",

Economic fundamentals are the headwinds against the U.S. monetary policy. It further supports my long position on TLT.

Conclusion:

Long TLT. Target price is just over $100 (9% return). $105 is possible (14% return).

Downside stop-loss is in the low $80’s (10% loss).

Risks:

Downside would occur if the stock market continues to rally, if the USD continues a spectacular decline, or if China’s continued stimulus program results in extended strength for commodities. Do not fight this trend. Take the loss to preserve capital.

Portfolio Management:

I have an initial 2% asset allocation in my kaChing portfolio, and intend on adding somewhere between 5-10% or more as the global events unfold and an established trend is identified.

Disclosure: I have a long position in my kaChing virtual portfolio. My kaChing portfolio is being followed by ~350 users. Note also that the 'Intelligent Investing' group that I moderate has 380 members.