A Bet on Higher Interest Rates - Short U.S. Treasuries

 |  Includes: TBF
by: Robert Hallberg

Interest rates are so obviously extreme in the opposite direction from the fundamentals and with record deficits, debts and unfunded liabilities, continued low interest rates will not be sustainable for much longer. Interest rates are already at 50 year lows and with a continued weakening dollar, there is only one direction for interest rates to go and that is up.

Except for some short bear market rallies, one can be fairly certain that the yield of U.S. Treasury bills will be going higher for years to come. Even Bill Gross of PIMCO, the bond king himself has dumped U.S. Treasuries from world's largest bond fund, which he manages. In an investment conference in Chicago, Bill Gross said that investors that are holding U.S. Treasuries will "get cooked like frogs in an increasingly hot pot of water."

The U.S. financial situation is not sustainable according to Bill Gross. He warns that 75% of the U.S. budget is entitlement-based and with Medicare, Medicaid and Social Security we are looking at $1 trillion deficits as far as the eye can see. These three entitlements already account for 44% of Federal spending and they are steadily rising.

Bill Gross concludes that unless these entitlements are completely restructured, he believes that the U.S. will default on its debts, not in conventional ways, but through inflation, substantially reducing the purchasing power of U.S. dollar.

Treasury bills are a triple threat to your capital

There is a triple threat against anyone holding Treasury bills. First you have the risk of a declining dollar, second you have a risk of higher interest rates and third you have the risk of the credit worthiness of the issuer.

1 – A declining dollar

With record budget deficits and trade deficits, the dollar will continue to be under pressure for as long as spending is out of control. The enormous unfunded liabilities are the root cause of the problem and they will need to be restructured before a solution can be reached. For example, Medicare is estimated to pay out three times more then what it receives from an average couple, so you can just do the arithmetic's to see that this is not sustainable. The chart compares external debt and unfunded liabilities to our tax base.
US debt & liabilitiesClick to enlarge
(Click to enlarge)

2 – Risk of higher interest rates

Interest rates reflect the "price of money" and must include expected inflation of the underlying currency. We currently have the lowest rates for a generation and the worst fundamentals of egregious government spending and deficit that have ever been combined in our history. Interest rates have temporary been held down by the Feds bond purchasing program, quantities easing (QE), which has been buying $100 billion worth of Treasures per month. But as QE 2 comes to an end on June 30th, we must rely on the market to pick up the slack of the Fed. The chart below shows the yield of 10 year U.S. Treasury bills. The 10 year Treasury bills went down to 2% during the financial crisis in 2008 and have been going higher ever since.

US 10 year treasury securities

Interest rates will also face upward pressure as inflation picks up. Anyone that has gone to the store lately knows that prices on almost everything are going up, despite the low inflation numbers the government publishes. ShadowStats recalculates the Consumer price index (CPI) without hedonic adjustments. In general terms, methodological shifts in government reporting have depressed reported inflation, moving the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living. The chart of CPI-U reflects inflation for today as if it were calculated the same way it was in 1990 and the CPI on the Alternate Data Series, reflects the CPI as if it were calculated using the methodologies in place in 1980. With traditional methods of calculating inflation it is easy to see that it is much higher than what today's CPI numbers suggest.

Inflation - Shadow statsClick to enlarge
(Click to enlarge)

Chart courtesy of shadowstats.com

3 – Credit risk

Based on our recent history, the credit agencies are usually the last party to acknowledge a problem. But Fitch has already warned the U.S. of a downgrade of its credit rating if spending is not brought under control. In addition, China's Gadong Global Credit Rating Company downgraded U.S. government debt to A+ from AAA.

Investment Implications

The dollar and U.S. Treasury bills will continue to be under pressure with the exception for a few bear market rallies. Since interest rates are already at record low levels they only have one direction to go and that is up. Shorting Treasures is a straight forward way of taking advantage of higher interest rates. However, I would recommend doing this on dips as the process of unwinding the bond bull market will take time and the FED could always step in and temporarily suppress rates with another round of QE or a similar scheme.

There are several ETFs and mutual funds that are tracking the inverse price of T-Bond, including:

  1. ProFunds Rising Rates Opp 10 Investor RTPIX, tracks inverse of 10-year T-Bond daily price movement
  2. ProFunds Rising Rates Opp Inv RRPIX, tracks 125% inverse of 30-year T-Bond daily price movement
  3. ProShares Short 20+ Year Treasury ETF TBF, tracks inverse of 20+ year T-Bond daily price movement

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TBF over the next 72 hours.