Why Shorting U.S. Treasury Bonds Is A Safe Investment

Includes: SBND, TBF, TBT
by: James A. Kostohryz
I have written extensively on why it is highly unlikely in the long run that U.S. 10Y Treasury yields (^TNX) will be sustained anywhere near 2.0%.
In my article, “Why Long-Term Treasury Yields Will Certainly Rise,” I show that there are essentially three possible macroeconomic scenarios, and that under each scenario long-term Treasury rates must rise.
  • The U.S. economy recovers. Long-term Treasury yields will obviously rise from current levels toward the 4.0% level at least.
  • The U.S. economy falters and default risk rises. Lowered tax collections cause U.S. fiscal deficit to balloon to levels that cannot be financed by private markets. Default fears rise causing long-term interest rates to spike. This scenario would be like that currently being experienced by Italy and Spain.
  • The U.S. economy falters and inflation risks rise. Due to the fact that it is highly unlikely that the U.S. Fed under a fiat monetary system would ever allow the U.S. to fall into a deflationary spiral that led to a default on public debt, inflation is the more likely outcome of a faltering U.S. economy. In this scenario of rising inflation, long-term Treasury yields will rise precipitously in the long run.
The Risk Of The Trade
When one is contemplating a trade it is important to know what the risks are.
In “How Low Can The 10Y Treasury Go (Part 1),” I demonstrate that 10Y Treasury yields cannot fall below zero under any reasonable set of assumptions. Indeed, I demonstrate that this proposition is more certain than taxes and about as certain as death.
But how low could yields fall? In this piece I review in detail the history of rates in the U.S. since 1871. I also review the history of Japan during its deflationary episode as well as its JGP bubble a few years back. The conclusion of this analysis is that taking the U.S. as the relevant precedent, rates will never be sustained below 2.0%. Even if one takes Japan as a precedent, rates will never be sustained below 1.0%.
Knowing that 0% is an absolute limit for 10Y yields is an extremely important insight when considering a short of long-term U.S. Treasury Bonds. It is also important to understand historical precedents in the U.S. and Japan. These point to the fact that the downside of a short of long-term Treasuries is in fact much more limited than even the zero-bound limit would suggest.
Incredible Reward/Risk
When you short 10Y U.S. Treasury bonds, your downside risk is strictly limited. In a worst-case Japan-style scenario, yields could fall to 1.0% (even though they could spike beneath that level as they have on a few occasions in Japan).
However, the upside of the trade is that yields go toward 3.5% at least in a scenario of a recovering economy. The default risk scenario would probably take rates well beyond 5.0%. And then there is the non-trivial risk of an inflationary outcome that could take rates into double or even triple digits.
There are very few investments that offer the sort of lopsided reward/risk that is offered by shorting long-term U.S. Treasuries. Unlike virtually any other investment, the downside risk of this trade is strictly limited.
Unlike other shorts, there is zero prospect that the value of U.S. Treasury Bonds could surge significantly given the zero-bound interest rate limit. On the other hand, there is absolutely no limit as to how far the value of U.S. Treasury bonds could fall.
Thus, shorting U.S. Treasury bonds provide a unique investment opportunity.
In a subsequent article I will discuss ways to implement this trade through such vehicles as shorting Treasuries directly, shorting bond futures and/or going long on ETFs such as TBF, TBT and SBND. It is very important to understand how these instruments work before implementing a trade.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT and long TBT and SBND.

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