Betting On An Interest Rate Reversal And Shorting U.S. Treasuries

Sep.12.11 | About: iShares 20+ (TLT)

The recent sell-off in the market has sent interest rates back to new extreme lows as fearful investors flee equities and turn to the safety of US treasuries. US government bonds are still seen as a temporary save haven, despite weak fundamentals. However, with interest rates already at 60-year lows and with record deficits, debt, and unfunded liabilities, there is only one direction for interest rates to go and that is up. The chart shows a parabolic move of the TLT, an ETF that attempts to track the long-dated 20+ year US treasures bonds.

(Click chart to expand)

Short US TreasuriesClick to enlarge

US treasuries have had a remarkable rally that started around mid-February and proceeded to make a parabolic move in July. I believe that this rally in treasuries, especially in the more long-dated treasury bonds, is unsustainable and likely to make a correction in the near future. The rally in treasuries was driven by a flight to safety, but given its low returns and weak fundamentals it is not a place where most investors will park their money long term. The chart too seems to indicate that TLT is substantially overbought and should be ready for a correction.

It is worth noticing that a similar chart pattern has previously been formed. TLT spiked much like the current chart indicates during the financial panic back in 2008, followed by an equally significant reversal. It is highly probable that a correction similar to the one of 2008 will follow. Needless to say, rates are already at a bottom and cannot go much lower.

We are not alone in this trade; savvy billionaire investors such as Jim Rogers and Bill Gross have also started to short long-dated US government bonds. Bill Gross, the bond king himself has eliminated long exposure and attempted to initiate short exposure to treasuries. In an investment conference in Chicago, Bill Gross said that investors that are holding US Treasuries will "get cooked like frogs in an increasingly hot pot of water."

There are several ways of shorting US government bonds but I would recommend buying out-of-the-money put options of TLT since it is a relatively inexpensive play and yet offers large upside potential. January 21, 2012, or March 17, 2012, put options with a strike price around $100 are reasonably priced and a good investment vehicle for our purpose. They are deeply out of the money, but they tend to multiply in value once the market moves toward the strike price.

This is a speculative trade and as with any options trading there is significant risk involved. I would only recommend allocating a small portion of your portfolio into this trade. However, with history on our side, I believe that there is a good probability that this trade will work out in our favor.

Disclosure: I am short TLT.