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1.99%: The US 10yr Treasury Paradox and Implications

|Includes:IEF, iShares 3-7 Year Treasury Bond ETF (IEI), JFR
http://reasonablythinking.com/2011/09/02/1-99-the-us-10yr-treasury-paradox-shorted-iei-20110902/


I spent minutes staring at this:  the US 10yr Treasury Bond finished the day at 1.99%.  I want the reader to first step back and think about the inherent paradox of investors buying a downgrade, and secondly, consider what a current and continued low rate structure implies.

Paradox

Last month, S&P downgraded the US’s sovereign credit rating from AAA to AA+ (with a negative outlook).  Since then, the US 10yr Treasury Bond yield has fallen from 2.40% to 1.99%.  This means that as US credit is officially considered to be worsening, more investors are buying it!  The opposite is normally true:  when a country is downgraded, investors normally demand higher compensation for lending funds to that country.  In the US’s current situation, the country suffered a downgrade and investors now demand less compensation for funds lent–quite the paradox!  I believe this situation to be unsustainable.

Implications

Suppressing interest rates to abnormally low levels both hurts the economy and the currency.  My assumptions are as follows:

  • An economy is based on what it produces
  • New sources of production depend on businesses investing in capital expenditures
  • Financing for capital expenditures depends on another party saving money (forgoing consumption)
  • Saving money requires an incentive of high interest rates

AND

  • Printing money to enable low rates (via purchasing treasuries) devalues the currency
  • A devalued currency appears as broad-based inflation with increased commodity prices

Today’s Trade

 I argue that the economic malaise, devalued currency, or both, will not be tolerated over the next few years.  I have already established investment positions for an economic downturn, and I have multiple positions that hedge against the US Dollar (see Commodities and Coins allocation in this pie graph).  Today’s trade directly attacks the yield curve.  I strongly believe that the US 10yr Treasury Bond will yield significantly higher than 1.99% in a few years.  I choose to short the 3-7 year portion of the curve by shorting 15 shares of IEI, which is a bond fund ETF mimicking the Treasury Yield curve, at $121.70.  Ideally, I would have like to have also shorted IEF, which is the 7-10 year portion of the curve, but shares of the ETF were unavailable for shorting; I may revisit this next week…  And for those of you who are long-time followers, I still own JFR and would consider purchasing more at a lower price.

Stocks: IEI, IEF, JFR