Description
I am going to recommend that you short intermediate to long-term US treasuries
because it is one of the last asset class bubbles going today and unlike the other bubbles, it has inflated substantially to all time highs while all other asset classes have suffered.
Due to
technical factors, investors have sold (dumped) almost all risky assets
and have rushed to buy US treasuries. As a result of this flight away
from all assets perceived as risky, treasuries have become incredibly
overvalued. The short end of the curve is telling as T-bills (even
prior to the recent move by the Fed to lower the target fed funds rate
to nearly 0% were already trading at or close to 0% yield. The yield
even went negative briefly with bids on certain short-term treasuries
actually higher than the interest + par to be received till maturity!
The current curve is as follows:
1 Year 0.39%
2 year 0.87%
5 year 1.47%
10 year 2.14%
30 year 2.62%
Although near term expectations are for the economy to enter a bout of deflation, the government is doing everything in its power now to
reflate the economy by "throwing money out of helicopters" to quote an
old Bernanke speech. In this battle, since the govt. and the Fed can
and will conspire to print money, the forces of inflation have to win.
It has not worked immediately because although the quantity of money in
circulation has exploded already, the velocity of money has dropped recently
as shell shocked consumers and financial institutions have been shocked into reining in their activity thereby masking the increase in the quantity of money for now.
However, it is extremely likely that the coordinated actions in the US
and elsewhere will have their intended effect and that the economy will
be re-inflated. In addition, it is hard to sustain gloom and doom forever. People can defer purchases and activity for a while, but some of the activity eventually has to normalize the velocity of money at least somewhat higher. As this becomes evident, the above yields will be too
low and investors will sell off their positions, driving prices down very rapidly.
Although you can simply short long-term treasuries directly, or perhaps directly use financial derivatives with a good counterparty and security, another
(perhaps logistically easier) way to implement the trade is to consider
purchasing (going long) TBT - the Proshares Ultrashort Lehman 20+ Year
Treasury. This ETF utilizes derivatives and financial instruments that
are indended to deliver twice (200%) of the inverse of the Lehman
Brothers 20+ US Treasury Index. Because of the recent flight to
safety, TBT has fallen approximately 50% since August 2008, from around
$70 per share to a current price of around $35 per share.
Just so you know what you are shorting, the Lehman Brothers 20+ Uear
Treasury Index includes ALL publicly issued, U.S. Treasury securities that have a remaining maturity greater than 20 years, are
non-convertible, are denominated in U.S. dollars, are rated investment
grade (at least Baa3 by Moody’s Investors Service or BBB- by S&P),
are fixed rate, and have more than $250 million par outstanding. The Index is weighted by the relative market value of all securities
meeting the Index criteria. Excluded from the Index are certain special
issues, such as flower bonds, targeted investor notes (TINs), U.S.
Treasury inflation protected securities (TIPs), state and local
government series bonds (SLGs), and coupon issues that have been
stripped from assets already included. So basically this is the right
one to short because is is very broadly diversified and liquidy index among
long-duration treasuries.
Currently, TBT is trading just a hair above its 52-week low of $35.51
(Price on 12/23/2008 of $36.62). Today the volume traded was 3.7
million shares (versus average 3 month volume of 1.338 million) so well
above average volume indicating high interest in this trade. At 3 million
per day, the volume is around $100 million per day which should be more
than enough for most VIC members interested in this short (through the
EFT).
Of course, is you long this ETF, you have a leveraged position in the
short which increases your risk somewhat. Since the manager is
utilizing a combination of leverage and/or derivatives, there is some
counter party risk which is difficult to quantify. Though I looked for it, I did not see a way to find the specific counterparties, collaterial, securities underlying this ETF. This is not ideal, though given the liquidity of the treasury market and this index on the long-side, it is not difficult to imagine that there would be a fairly long-list of banks and others that would take the other side of this trade.
The risk
essentially is along the lines of the following: Treasuries could
implode, but through either botched implemention of the trade by the
investment manager (Proshares) and/or due to a counter party default,
the ETF might not rise 200% of the movement in treasuries - and in the worst case it could even fall. This is
probably not a high probability at this point since the Fed has more or
less indicated that most of the surviving investment banks are "too big
to fail" and will be bailed out going forward (which may not even be
necessary). Also, TBT trades in the market so you can sell for your
gain as long as the manager does not announce a failed counterparty
right away.
Looking at the extremes in the treasury market at present, this is a
high upside and low downside trade. If deflation fear continue for a
while longer, there may be a bit more downside on these shares, but
probably not much more. It is hard to image long-term treasuries going
much below 2% on the 30 year. Since the dollar is falling and Fed is
printing money as fast at it can, this is quite bearish for long-term
treasuries currently trading far above PAR. There are many ways to win and relatively few ways to lose. I would think that this ETF could quickly move up around 50 to 100% in the next 6 to 18 months from now for a very attractive IRR from current levels.
Catalyst
* Fear subsides
* Inflation increases
* Foreign investors start selling Treasury positions
* Markets start to recover inducing investors to pull money out of treasuries and into somewhat riskier assets