Profit from Weak U.S. Balance Sheet: Short Government Debt

One of most common and least sexy trades throughout the global hemispheres of market movers is the U.S. Treasury bonds trade. Those brave enough to dive long into equities or commodities on the shoulders of the current are both delusional and progressively dwindling in numbers.

This has rebuilt a twinge of respectability among current traders, as a "topping out" formation is building among equities in recent weeks. Searching for a fruitful tree still standing to shake, the smartest guys in the room have already begun talking about the money to be made by shorting the U.S. government's debt. In an environment wrought with risk, limited reward and potentially devastating geopolitical factors, why not short the only asset that is still ridiculously overvalued?

That's right, short the long-term U.S. Treasury debt. Initially supported by the $300 billion Fed purchase plan, the debt has begun rotting away and compounding in an environment potentially void of future U.S. government revenue growth.

It's plainly evident that the 10 Year U.S. Treasury Note yield increased into the early 1980s near the point where mortgage rates peaked at 18.45% for a 30 year fixed rate product, in October 1982, and the "S&L (Savings & Loan Bank) Crisis" began. Since the 1981 high yield of 15.84%, the 10 Year Note has neared the point of zero amidst accelerating deficit spending over the past decade.

The U.S. yield curve, based in a soppy overnight rate at 0%, has been tamed by Ben Bernanke's $300 billion program to buy 10+ year Treasury obligations and the less public Federal Reserve purchases of "toxic assets" from the GSEs and government owned banks (Citi (C) and Bank of America (BAC)). Recent decisions to remove these two methods of backstopping American finance will effectively release the long end of the yield curve out into the wild.

Interestingly, the Fed concluded to remove these measures amidst a climate of stagnation in economic activity and talks of further stimulus on Capital Hill, both headwinds to the perceived solvency of the U.S. government.

The strategy of shorting U.S. Treasury Debt is the only strategy that makes you money over the medium term regardless of nearly every possible economic outcome. Should the economy recover and the Federal Reserve begin quantitative tightening by raising short term rates, long term rates will also rise as demand will fall for government debt replaced by riskier assets.

If the economy turns back into contraction and stocks fall, demand for treasuries may spike temporarily but the bid to cover ratios in current auctions already signal un-sustainably high demand and will only drive yields lower for a very short time.

As the economy weakens and stocks continue to fall , investors will pull out of U.S. government bonds due to fears of revenue destruction and insolvency. In the contraction scenario, there will be no desire to lend to the debt heavy U.S. government as Uncle Sam's AAA credit rating is again called into question.

The final risk to this strategy identifies the recently narrowed U.S. trade deficit, which had contributed to the steadily increasing demand for long term U.S. debt since 1982. Surplus dollars received under more unequal trade levels by foreign counterparts were invested almost completely in American bonds, thus driving the yields continuously lower and further perpetuating the American consumption that was fueling the deficit growth in the first place.

This however is the final bubble which has yet to burst that will finally cleanse the over-leveraged consumption by the developed world, having followed the lead of the United States. In the unlikely event that U.S. consumption returns and trade deficits resume, trade partners have already shown their desire to hold tangible assets, signaled Tuesday by India's trade of 6.7 billion USD for 200 tonnes of gold (7% of the world's annual gold mine production).

It is therefore our view that any "risk" of a resumption to the previous norm of global trade inequalities is counterintuitive and that growing imbalances with India and China will discourage policies to bloat their surplussed coffers with the final toxic asset... U.S. government debt.

To implement this strategy it is easiest to simply buy the Direxion Daily 10 Year Treasury Bear 3X Shares ETF (TYO). This ETF gives you enough leverage (3X) to profit from the relatively minor swings in Treasury yields and is much safer than actually shorting the U.S. 10 Year Note, because your losses are limited to the initial investment made. Make note, this fund will fluctuate directly proportional to the yield on the 10 Year Treasury Note and inversely to the price.

Disclosure: Author is long TYO

Comments

[Dave Wrixon:]

Basically what you are saying is the US is in a Lose-Lose situation, so yes Shorting is Win-Win. But is not just the debt that is going to hell. It is also the currency in which the debt is denominated. However, their could still be severe gyrations as confused investors still talk about the US currency being a safe haven. Nothing will crystallize until this ridiculous illusion is shattered once and for all.

Nov 05 06:08 AM

[Mad Hedge F...:]

ndu I know what keeps Obama awake at night. Let’s say we spend our $2 trillion in stimulus and get a couple of quarters of weak growth. Then once the effects of the stimulus wear off, we slip back into a deep recession, setting up a classic “W.” Unemployment never does stop climbing. This happened to Roosevelt in the thirties. So congress passes another $2 trillion reflationary budget. Everybody gets wonderful new mass transit upgrades, alternative energy infrastructure, and bridges to nowhere. But with $4 trillion in spending packed into two years, inflation really takes off. The bond market collapses, the dollar tanks big time, gold goes ballistic to $5,000, and silver explodes to $50. Ben Bernanke has no choice but to engineer an interest rate spike, taking the Fed funds rate up to a Volkeresque 18%. Housing, having never recovered, drops by half again. This all happens in the 2012 election year. Obama is burned in effigy, a Mormon is elected president, and the Republicans, reinvigorated by new leadership, retake both houses of congress. We invade Iran. Crude hits $500. This is not exactly a low probability scenario. Remember Jimmy Carter? This is why junk bond yields are still stubbornly high at 12.5%, and credit default swaps live at lofty levels. Are the equity markets pricing in this possibility? No chance. The risk of Armageddon is still out there. Personally, I give it a one in three chance. Pass the Xanax.

Nov 05 09:42 AM

[Daryl Montg...:]

While I am not optimistic, your Doomsday scenario isn't necessary to get the commodity prices you predict. Simply printing too many dollars and supply issues will do it. As for raising interest rates to Volcker levels, if the U.S. did so, the interest payments on the national debt would absorb all federal tax payments and there would be no money left to run the U.S. government. So we would have to print the money to do so, which would lead to more inflation and still higher interest rates. That would be the end game.


On Nov 05 09:42 AM Mad Hedge Fund Trader wrote:

> ndu I know what keeps Obama awake at night. Let’s say we spend our
> $2 trillion in stimulus and get a couple of quarters of weak growth.
> Then once the effects of the stimulus wear off, we slip back into
> a deep recession, setting up a classic “W.” Unemployment never does
> stop climbing. This happened to Roosevelt in the thirties. So congress
> passes another $2 trillion reflationary budget. Everybody gets wonderful
> new mass transit upgrades, alternative energy infrastructure, and
> bridges to nowhere. But with $4 trillion in spending packed into
> two years, inflation really takes off. The bond market collapses,
> the dollar tanks big time, gold goes ballistic to $5,000, and silver
> explodes to $50. Ben Bernanke has no choice but to engineer an interest
> rate spike, taking the Fed funds rate up to a Volkeresque 18%. Housing,
> having never recovered, drops by half again. This all happens in
> the 2012 election year. Obama is burned in effigy, a Mormon is elected
> president, and the Republicans, reinvigorated by new leadership,
> retake both houses of congress. We invade Iran. Crude hits $500.
> This is not exactly a low probability scenario. Remember Jimmy Carter?
> This is why junk bond yields are still stubbornly high at 12.5%,
> and credit default swaps live at lofty levels. Are the equity markets
> pricing in this possibility? No chance. The risk of Armageddon is
> still out there. Personally, I give it a one in three chance. Pass
> the Xanax.

Nov 07 09:00 AM