Is It Finally Time To Short U.S. Treasury Bonds?

Includes: TBF, TBT, TLH, TLT, TMV
by: Maxsoar

I wrote an article last February expressing my bearish view on U.S. treasury bonds when the 10-year Treasury yield was at about 1.9%. I did not actually bet against treasury bonds at that time because, technically speaking, the upward momentum for treasury bonds was still very strong. As for NFLX, my major shorting bet in 2011, shorting against a stock/bond close to the top of the hype is a tricky and dangerous maneuver because it is hard to know where the exact long-term top of the stock/bond is and when the stock/bond will reach that top. In addition, the situation in Europe was still very dire at that time, which could have provided additional support for treasury bonds. My concern turned out to be real, and the 10-year Treasury yield continued to slide to an all-time low of just below 1.4% and has climbed steadily since. It has now gone a full cycle back to about 1.9%.

The million-dollar question pops up in my mind again: Is it FINALLY time to short treasury bonds? For investors who have a very long investment horizon, the decision is probably not so hard now as it was 10 months ago. I think very few people will be really satisfied with having their capital tied up in an investment for 10 years for merely a 1.9% annual return. Seriously, inflation is much lower than the historical average right now, but it is still at around 2% (I interpreted November's huge drop as noise).

However, for short-term investors, the picture is less clear. Several factors that may affect the movement of Treasury yields are as follows:

1. U.S. and world economies: The U.S. economy seems to be doing pretty okay lately. Many gauges of economy-weekly jobless claims, unemployment rates, consumer spending, housing market, factory outputs, etc.-have been improving over the past couple months. However, with only an okay deal on the fiscal cliff and the looming national debt limit coming in late February/early March, the outlook for the U.S. is uncertain right now. The European economy is still struggling right now. The hope for stronger global economic growth still lies in emerging markets. With new leadership stepping in, China's economy is expected to witness stronger growth in 2013 than in 2012. Some economists expect Brazil's economic growth to also rise in 2013. Overall, I have a slight bullish bias towards the U.S. and world economy in 2013. This factor alone should have a slightly negative effect on Treasury yields.

2. Yields of other sovereign bonds: Because sovereign bonds are competing investments, the yields of the sovereign bonds of other major countries will affect U.S. Treasury yields. The trends of 10-year government bond yields in Europe seem to be stable at this moment. Japan's 10-year government note yield seems to be rising. Hong Kong's 10-year government bond yield is showing a rising trend, too. So, the overall yields of the long-term sovereign bonds of major economies seem to be showing a tendency of mild upward movement. This will also put some pressure on the price of long-term U.S. Treasury bonds.

3. Demand for mortgages in the United States: With long-term mortgage rates at historical lows, the housing market is booming in the United States. If demand to purchase new homes continues to rise, even the Fed's effort to contain longer-term rate might not be able to fully counter the strong demand for mortgage at some point this year. In this case, mortgage rates will rise. In addition, the FOMC is already worrying about the effectiveness and negative side effects of the current over-sized buyback program and may cut the program sooner than previously targeted. Accordingly, I think the chance is high that mortgage rates will rise somewhat this year. This will also put a little bit downward pressure on U.S. treasury bonds.

There are certainly many other factors, such as appreciation/depreciation of the U.S. dollar and inflation that will affect Treasury bond prices. However, most other major factors will reflect themselves more or less in the three factors mentioned above. All in all, in my view, macro factors are putting a mild downward pressure on U.S. Treasury bond prices this year. There are several ways to profit from falling Treasury bond prices including going short on iShares Barclays 20-Year Treasury ETF (NYSEARCA:TLT) or iShares Lehman 10-20 Year Treasury ETF (NYSEARCA:TLH) or going long on ProShares UltraShort Lehman 20+ ETF (NYSEARCA:TBT), Direxion Daily 30-Year Treasury Bond ETF (NYSEARCA:TMV), or ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF). I like going long on ETFs that sell short Treasury Bonds because I have the option of selling calls to give me some protection if the ETS falls and to enhance my profit if the ETF stays flat or only rises marginally with a period of time. Of course, if I go short on ETFs that buy Treasury Bonds, I can still sell puts to achieve similar effect, but a covered call combo is easier than a covered put combo to handle when my option goes into money.

Figure 1 and Figure 2 show six-month price charts for TBT and TMV. The shapes of the two charts are strikingly similar, implying that the prices of the two move roughly in tandem. However, the percentage spread between the two narrowed from 20% (58.4/48.56) on 7/31/2012 to 15% (65.54/56.96), meaning that 30-year Treasury bonds depreciated more than 10-year Treasury bonds did during the period. Naturally, option premiums for call options of TMV are higher than option premiums for TBT. As of January 9, 2012, at money February call options with a strike price of $57 had a premium of roughly 4.65% (2.65/57). In other words, if TMV stays below $57 from January 10, 2012 to February 15, 2012, the call option seller will earn a 4.65% return in just 5.4 weeks. That's an annualized return of 54%!

Because both ETFs are current at the upper portion of Bollinger band and the short-term price range is as shown in the charts, going long on TMV/TBT and writing covered calls every month is more appealing to me than simply going long on TMV/TBT. If their prices drop to the bottom of the short-term range, I will be more inclined to simply go long on either ETF.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TMV, TBT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.