Why I Am Shorting Treasury 30 Year Bonds via Treasury Futures

Includes: TBT, TLT
by: Robert Weinstein

$38,000. For a fortunate few, $38,000 might be a bill for a weekend in some exotic place that includes the finest of food, drinks, and accommodations. For others, $38,000 might be the price of the car that they are going to buy, either through financing or a single stroke of the pen. $38,000 may be a down payment for a home or used to purchase of some critical business equipment. For the vast majority, $38,000 either implies wealth or a significant investment. In other words, $38,000 is a lot of money.

Regardless of who you are in America, we all have one thing in common with this $38,000 sum. If you were to average out the debt of the United States of America to the roughly 300-310 million citizens, it would come to be about $38,000, very likely even MORE per person by the time you read this (as the debt is actually growing much faster than the population). In fact, the debt of the US is growing faster than $3 billion per DAY and doesn’t take time off for weekends and holidays.

In the US, our population, GDP, disposable income, and overall wealth continue to be overshadowed by our debt and the amount of money we spend on debt servicing (interest payments) continues to rise, as well. The reason for this is pretty simple. As a nation, we are spending more than we bring in. The reason for this is also simple and is nothing new; history is repeating itself once more. Some will call it the ‘tragedy of the commons,’ others will call it ‘politics in DC’ or ‘Untended Consequences.’ Still others will call it ‘Socialism’ but the end result is the same: massive destruction of wealth, freedom and liberty along with a double scoop of government bureaucracy along the way.

In my opinion, the US will not stop spending relative to the tax receipts under the current system which has both an income tax and universal suffrage. When you create a republic form of government and add universal suffrage, you exponentially increase the number of voters that have self interests not in line with the interests of the nation as a whole. An extreme example would be someone who is capable of working but chooses not to because they can make do with government programs. This includes welfare moms, seniors, and the disabled who know they will receive fewer benefits if they earn too much (for example by working or any wealth building activity). Some are outright “scamming” the system and others are following the rules as they are made, but all are doing what is in their own best self interest. Whatever they are getting of value has no direct cost to the recipient. That in itself creates inefficiency as well as waste as well as administrative costs by the government.

Of course in some cases, self interest can benefit the nation. When an inventor creates a new technology, they may become rich, but if the benefits of the product are widespread and aligned with the general interests of the country, wonderful things can and will happen. People buying and selling a given commodity on an open market is another great example. The average person will be able to get the best price they can (either as a short or long) compared to a government preset price. As such, the system clearly has the potential to become efficient, but for the system as a whole, it is an issue of balance. If you offer people payments for not working (unemployment insurance) you will actually RAISE the number of people that are unemployed as some people will decide that it is in their best interest to not work and just collect a ‘free’ check. So having unemployment insurance distorts the market and causes the price of labor expenses to go up as some of the supply gets taken out of the market.

The above the examples show what is actually happening with the Federal Government: we are repeating history, setting the stage for the next tragedy of the commons. Once a government program gets put into place, no matter how unnecessary, there will always be blocks of voters that benefit from the program. This is how temporary laws become permanent and very hard to break. Take, for example, rent control in New York City, which started out as a temporary measure over 60 years ago during World War II. The only reason it doesn’t go away is that there are city council people that have blocks of voters that keep them in office regardless of the fact that it is detrimental to the overall city/state/area economy.

The same can be said about Washington DC. Politicians have learned that having various government programs that benefit a clearly identifiable group is a sure way to maintain and grow their own interests, power, and status. Since costs are not directly paid for by the politician, their district, or the state getting the benefit, the politicians are not motivated to end programs even when they are driving up debt, requiring the US to borrow from countries that do not share our interests. One cannot expect the politicians as a group to act in ways that are not in their own self interest even if it goes against the overall interests of the nation. Special interest groups have no qualms about steering politicians in this same way, because their costs are not proportional to the benefits they will receive.

None of this will change, unless change is forced upon us in such a way that we have no other options. Why would those in Washington upset their ability to gather power and status? Many would blame Obama, saying that he is sending us down the wrong path. I would not point my finger at the current administration because I would be so busy pointing my finger at so many members of Congress first that I would be worn out before I had the chance to get to the White House (not that they are innocent by any means). Congress is also made up of representatives voted in by anyone over 18, thanks to Universal Suffrage, many of which could not even name the person currently representing them, much less what they stand for.

Many voters do not possess the ability to balance a simple checkbook, but they certainly know what is in their own self interest based on what they are told they will get if they vote a certain way. There are also voters that do have a fundamental understanding of economics that will still vote in their own self interest, even if it goes against the overall good of the nation. Unfortunately, it is only a minority of voters that understand the issues and the economic ramifications of what goes on in Washington. Often, the biggest impact they make is when they go against what appears to be their own personal interests. Some seniors, for example, are willing to go against a raise in social security or Medicare spending. This actually IS in their own self interest, too, as they are trying to ensure that their children are not forced to pay more than the economic value of social security.

The overall imbalance of self interest and national interest has brought us to where we are today. Elected officials are less focused on lower spending and more focused on how to bring in special interest voters with expensive health care, military spending, and entitlement programs. This raises the cost of health care (if you believe in current economic theory you cannot increase demand without increasing the cost), military costs (future budgets are usually based on past expenditures resulting in a spend spend spend attitude of military brass), and entitlement programs that guarantee very LARGE blocks of interested voters (when was the last time you heard a politician talk about lowering the social security benefits as a way to cut the federal budget?). Even though many believe it is in the best interest of the country to change social security you will not hear it from any statistically significant number of elected officials because its not in their self interest.

So while we find ourselves with over $38,000 in debt per man, woman, and child in the US, it seems we are moving no closer to resolving this debt. The US budget deficit went over $1.2 trillion for the current fiscal year and we have two more months to go. We have also found that the FED has been buying Treasuries in order to keep the interest rates down. The FED hasn’t been buying a little either. The FED program of buying debt is scheduled to be in the ballpark of $300 billion. Without the FED buying, it is hard to imagine how the interest rates would be as low as they are. It has been reported by Bloomberg that the FED has spent over $250 of the $300 billion so far and that they expect to have spent the entire $300 billion by October 2009. After October, if the FED does not continue to buy and the Treasury continues to issue notes/bonds at a rate that requires higher rates of interest than the current amount with the FED buying, the rates will go higher. Of course the FED could decide to raise the amount of buying and go beyond the $300 billion to continue holding rates down but how long can this go on? Even if the FED does continue to buy past October, we are still faced with the fact that it’s all relative to the amount of debt the Treasury wants to issue and the amount of debt that the market wants to buy, bringing the real question to center stage.

Will the proportion of buyers of US debt to the amount of debt that Congress allows us to accrue remain the same or higher (causing rates to go down) so that interest rates will remain the same? It is my belief that the answer to this question is NO. Given enough time, that rates will go up due to one of two reasons:

  1. Either the economy will improve and capital will flow to other investments, causing the Treasury to offer higher rates to fulfill the spending wants of congress, or
  2. The number of buyers of Treasury debt will go down and rates will go up due to the perceived risk of inflation of the US dollar.

We have already seen what happens when the Chinese don’t come to the table and take a full helping of Treasury debt: the rates go up. We also are seeing some jawboning by the Japanese that they have a ‘full faith’ in the US debt, which of course is in their own self interest as they own over $600 billion in current value of our debt. I think its safe to say that the Japanese would rather not see this debt’s worth reduced to $400 billion overnight. On the other hand, some may think the Chinese would never do anything to upset the apple cart as they own over $700 billion of US debt. This type of thinking is overly simplistic – it goes against their self interest. If we take a stroll back in history we can see that the Chinese not very long ago not only dominated Asia but also believed (rightly or wrongly) that they were the center of the world in economic and military power. While the Chinese may have hit a speed bump during the 20th century (especially during Mao’s power) they are clearly back on track to take what they believe if their rightful place in the world. If this means they have to take a ‘hit’ with some Treasury notes it will NOT be looked as a loss of investment but rather a COST to take their place as the number one power. Those that think the Chinese will not at some point dump the Treasury notes when it will hurt the US the most are missing an important point. We also cannot overlook the Japanese, who will likely one day become sellers of US debt to fund their retirement as their population ages. The Japanese were once the number one buyers of US debt, so when they become net sellers, the upward pressure on rates will be unbearably high.

Do I think that rates will go up next week? No. Far be it from me to guess and it is useless to try to time it with the thinking of both the buyers and the sellers of the Treasury notes. I do believe that the rates will go up, however, given how low they are now (historically), our never ending appetite for spending, and the potential for major buyers to step away. Because of all this, I have begun to short the 30 year Treasury bonds via the Treasury futures / futures options and plan to increase my short position during strength in the futures. I plan on doing this by primarily selling out of the money calls on the futures to take advantage of time premium and to lower my overall risk as the market bounces around.

Disclosure: I am short 30 Year Treasury Futures / Options