Taking Aim At U.S. Government Debt

 |  Includes: AGNC, BBK, CIM, KTF, NLY, NUV, TBT, VMO
by: Shmulik Karpf

The U.S debt market is the most important financial market in the world. All the financial instruments we know either depend on it directly or are highly correlated with it.

How big is the U.S debt, really?

As of February 2012, the "debt held by the public" was $10.7 trillion and the "intra- governmental debt" was $4.8 trillion, for a total of $15.8 trillion. That is 15 with a dozen zero digits after it. It is almost inconceivable. Only the annual interest payments to service this debt have exceeded the staggering amount of $430BL.

But that is merely one part of the big picture. You see, the figures above do not include the guarantees of the U.S to its agencies, such as Freddy Mac (OTCQB:FMCC), that are currently in excess of $100BL. Not only that, there are much bigger expenses that are excluded from the "standard" calculation of debt. For example, Medicare alone which is considered an "unfunded obligation" is estimated at $38.2 trillion.

These amounts of debt are obviously unsustainable. They are only seemingly sustainable because of our inherent belief in the system and in what it represents. The truth of the matter is that no country, including the U.S., can service these amounts of debt. Certainly not by paying a measly 2% as interest on those massive debts. The U.S should pay 4 times that rate.

A domino effect

Once the price of debt begins to fall (yields begin to rise), the process will not end with U.S treasuries. It will greatly and immediately impact other markets.

It will start with other local debt markets such as the municipal debt which was almost untouched last year. The rising yield on the U.S. debt will force local municipalities to pay more for their debt. This in turn will decrease the price of municipal paper holders such as the Nueevn Value Municipal Fund (NYSE:NUV), Invesco Municipal trust (NYSE:VMO), Blackrock Municipal Bond Trust (NYSE:BBK) and Municipal Income Trust (NYSE:KTF).

The next wave will hit mREITS which are companies that hold mortgages and profit on the spreads between the long-term and the sort-term curve. Once yields on U.S. treasuries rise, their spreads will shrink and so will their profits and their highly awaited dividends. The usual suspects are Annaly (NYSE:NLY), Chimera (NYSE:CIM) and American Capital Agency (NASDAQ:AGNC),

The foreign exchange market will not remain untouched, of course. Since the U.S. must pay more (in terms of yield) to service its debt, it is more likely to inflate its debts away by money printing. This will lead to a massive devaluation of the dollar, which in turn, will lead to a spike in the prices of "hard" commodities such as corn, soy, cotton, coal and fuel. It is already happening as we speak.

Great timing

I have been watching this trend for quite a few years, and I was not able to find a good entry point for shorting U.S. debt.

You see, Bill Gross, the legendary bond investor, sold out his positions in the U.S. bond market by mid 2011, citing the end of QE2 as his biggest fear. He claimed that he does not wish to participate as a buyer in such a bond market. As you can see from the graph, Gross missed the "run of a lifetime" in U.S. bond securities.

But finally, the price is beginning to crack down. Yields on 10-year notes jumped from under 2% to over 2.35% in a matter of days. The strong and tested level of resistance at the $115 has been violated on the way down, and we are currently down by more than 10% from the December 2011 highs of $124.

This is a signal for a new trend. A downward trend. I believe that the time has come for us to short the U.S debt market.

The bear case against my theory

Many investors and traders alike say that now is the beginning of a new era, an era in which exaggerated amounts of debt can be serviced as long as the debtor is a world dominator that can simply print its debts away such as the U.S. These proponents also liken the U.S. debt to Japan's, which has been maintaining its national debt at record lows of about 1% for over two decades.

To those proponents I answer that the U.S. does not have the privilege that Japan has. Almost all of Japan's debt is held inland, i.e., either by the government or the banks, whereas U.S. debt is held by foreigners who own $4.45 trillion of U.S. debt, or approximately 47% of the debt held by the public of $9.49 trillion. You can see the table, here. In fact, only China alone, which is the biggest creditor of the U.S., represents the largest single holder of U.S. government debt, with 26% of all foreign-held U.S. Treasury securities (8% of total U.S. public debt).

When you have such a substantial creditor, he can easily demand higher interest on debt. Since yields move in inverse direction to the price of the bond, this creditor can drive the price of U.S. debt down to the ground.

Action To Take

There are various ways to short U.S. government debt, but I believe the most straightforward of them all is to short the IShares Barclays 20+ Year Treasury Bond ETF, also known as the TLT.

I recommend to short TLT at current price levels (~$110), and place your stop loss at $120 to limit your downside risk. We will take profit at $80. Because of the sensitivity of this trade, I will follow it closely and issue timely updates on it

Alternatively, you can also purchase long-term put options on TLT or buy the iShares Ultrashort 20+ Year Treasury Bond ETF (NYSEARCA:TBT), but those are likely to be much more volatile and cause traders a greater deal of pain.

Disclosure: I am short TLT.