Rationale Behind Shorting Treasuries ~ market folly

Wednesday, November 12, 2008

Rationale Behind Shorting Treasuries

For all intents and purposes, U.S. Treasuries are setting up to be a great short opportunity. Last week, I laid out a basic thesis for shorting treasuries. We may be early in this call, but present and future actions are sending us signals we simply cannot ignore. The presently increasing and future supply of treasuries is simply too large. As Martin Hutchinson over at Money Morning has highlighted,

"The U.S. Treasury Department announced Nov. 3 that it intended to borrow a record $550 billion in the fourth quarter. That represents a staggering $408 billion increase over Treasury's borrowing estimate from early August and includes $260 billion for the recapitalization of U.S. banks. Make no mistake about it: There will be enough U.S. Treasury bonds to choke on, as the government tries to finance this debt."

All signs point to this trend continuing. In the quarter prior, the government borrowed $530 billion. Now, with the recent news out that they will borrow an additional $550 billion, the question becomes, when does it end? The current flooding of the market with treasuries is reason enough to get short them. But, with the impending tsunami of future government borrowing still to hit, it just makes the bet that much sweeter. Hutchinson goes on to say that,

"Inevitably $800 billion to $900 billion of additional money flowing from domestic investors into Treasury bonds will do three things:
  • It will drive up interest rates on Treasury bonds.
  • It will tend to crowd out other financings, making finance difficult to obtain for medium-sized and smaller companies and more expensive even for the behemoths.
  • And finally, it will increase inflation, as the Fed is forced to expand money supply to give investors enough money to buy all the Treasuries."

So, we can see that the consequences of their actions definitely plays right into our shorting thesis. The main point we're focused on here is the fact that interest rates on Treasury bonds will rise. When the yields increase, prices will drop, thus benefiting our short position. And, the case can easily be made that the longer dated treasuries will suffer the most. After all, do you want to loan the government money for 20 years at a paltry interest rate? We didn't think so.

Warren Buffett was even out mentioning the under-performance of cash equivalents in his latest comments. He wrote,

"Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."

Now, although Warren was using that argument to make the case for buying equities in his piece, his point is that cash and cash equivalents will underperform and are thus not desireable. And, a basic principle of investing is to go long outperformers and short underperformers. Cash and cash equivalents (treasuries) are set to underperform and thus make a delicious short for you to sink your teeth into.

The actions of the government not only lay out the premise for shorting treasuries, but also the US Dollar. As inflationary pressures will weigh heavily on the Dollar in the future, eventually something has to give. The only problem here is that other forces are at work on the US dollar as the world continues to deleverage and hedge funds are forced to sell assets and continue to face redemptions. So, this play could ultimately take even longer to play out. But, we will address shorting the US Dollar in a separate post further devoted to that rationale.

The main thing to take away here is that the government has demonstrated that they have and will continue to borrow money by the hundreds of billions. As yields on treasuries rise, prices will drop, especially on longer-dated treasuries. Now, the question becomes how exactly do we play this? Not everyone has access to shorting the 10 year and 20 year treasuries outright, so I am here to offer some other alternatives. As I laid out in my first post on shorting treasuries, there are a few vehicles in the stock market that one can turn to, such as tickers PST and TBT.

PST is the ETF for UltraShort the 7-10 year treasury. An Ultrashort ETF seeks twice the daily inverse of the underlying security. So, buying PST gives you twice the inverse of the performance of the 7-10 year treasury (effectively a double-short). Additionally, TBT is the ETF for UltraShort the 20+ year treasury. This ETF seeks twice the inverse daily performance of the 20+ year treasury (also a double-short). So, those are two very easy ways for people to get short treasuries by buying those tickers in the stock market. Additionally, Hutchinson suggests the Rydex Inverse Government Long Bond Strategy (Juno) Fund, ticker RYJUX as another way to play it. That fund takes various short positions in treasury bond futures and thus will also rise as treasury prices decline.

* 1/12/09 Author's note: Please be advised that since publication, we have further researched the PST and TBT trading vehicles are are NO LONGER recommending them as proper vehicles for shorting longer-dated treasuries due to their poor correlation to their underlying indexes over time. Instead, we are recommending a straight short of TLT. Expect a follow-up post soon.

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