Hugh Hendry On Gold, Treasuries, Japan, China & More: Buttonwood Gathering

It's been a long time since we last checked in on Hugh Hendry of Eclectica Asset Management so today we're highlighting his recent talk at The Economist's Buttonwood Gathering.  He touched on hot topics such as gold, treasuries, China, Japan, hyperinflation and a myriad of other things.

Key Takeaways

Hendry continues to like gold, but not the gold miners.  While he has been an advocate of the precious metal for many years, he continues to like it (albeit with slightly less conviction than previously).

We've highlighted one hedge fund's view that miners are better than gold and Hendry obviously disagrees with that.  And recently at the Great Investors' Best Ideas conference, David Einhorn made a quip that one should have gold miners in their portfolio.  Clearly, this is a divisive topic.

Hendry is also worried about creditor nations.


Notable Quotes From Hendry

Hendry said that, "My community of global macro managers always wants to short the JGBs and short the yen, and yet they've gone the opposite direction ... If you want to be short JGBs for the ultimate response, you don't survive the journey."

We've pointed out Kyle Bass' negative views on Japan and JGBs in the past.  Hendry points to real problems coming in Japan should some of their major companies near bankruptcy (he mentioned Sharp).

Hendry on Treasuries:  "Don't tell me China will sell their US treasuries.  If they sell their treasuries, the renminbi goes higher and higher and higher.  And their companies that export go bust."


Embedded below is the video of Hendry's entire talk at The Buttonwood Gathering:



We've previously highlighted some of what Hendry was buying earlier this year.  And for further hedge fund commentary from the Buttonwood Gathering, head to David Einhorn's talk.

Ten Reasons To Buy Bonds

Earlier this morning we presented the first quarter investor letter from Broyhill Asset Management's Affinity hedge fund where we highlighted their contrarian bet on long-term treasuries. In a time when seemingly everyone is betting on inflation, Broyhill has taken a converse stance and thinks caution is warranted. They anticipate an acceleration away from risk assets and into fixed income. They recently posted up the rationale behind this position on their blog View from the Blue Ridge and we wanted to highlight the key takeaways from their deflationary wager. Thus, we continue our impromptu inflation versus deflation debate as we earlier cataloged how hedge fund manager Kyle Bass sees inflation & currency devaluation in store around the globe.

Believe it or not, Broyhill had previously been short treasuries and covered in March. They've since gone long and see the 10 year treasury as an effective hedge against deflation. They have been buying here and will continue to do so on any weakness. Investors wishing to jump on this seemingly contrarian bet can buy exchange traded fund IEF for 10 year treasuries, or TLT for 30 year treasuries if you wanted a longer duration. This investment of course is in stark contrast to the myriad of other hedge funds that have been shorting long-term treasuries. Hedge fund Broyhill's rationale for owning bonds is refreshingly presented with various research found via the financial blogosphere. You can of course keep up with Broyhill's latest thoughts on their blog, View from the Blue Ridge.

Before getting into the ten reasons, we'll first start with their chart of 10 year treasury yields that has been in a decisive downtrend for the better part of two decades. Various crisis events over the past twenty years have caused momentary spikes in treasury yields, only to later resume the trend of decreasing yields.

(click to enlarge)

And now, without further ado, here are Ten Reasons to Buy Bonds:

1. "Core inflation historically falls after the end of a recession. In the 11 recessions from 1950 through July 2009, the end of recession was followed by declining inflation, with CPI bottoming on average, about 29 months after the recession ended. Longer term inflation concerns are warranted, but there are more immediate threats in front of us."


2. "With core inflation declining and nominal economic growth rates weak in the aftermath of financial crisis, bond yields should trend lower in coming quarters. Investors looking to purchase long-term inflation hedges, should see more attractive entry points in the period ahead. Be patient."


3. "The average long term Treasury rate since 1870 is 4.3% and the average annual CPI is 2.1%. If inflation trends toward zero (before moving much higher later in the decade), then long term bond yields could naturally fall toward 2%."


4. "A near term deflationary environment bodes very well for long term bonds. Long term Treasury rates dropped from 3.6% in 1929 to 1.9% in 1941. Interest rates in Japan fell from 5.7% in 1989 to 1.1% in 2008 while the Nikkei dropped 77.2% over the entire period."


5. "The most common argument from Bond Bears is higher levels of debt must lead to higher yields. The reality is that the economic cycle still dominates intermediate swings in bond prices – a growing list of leading indicators are pointing to slowing economic growth ahead."


6. "The velocity of money is falling at the same time money growth has come to an abrupt stop. Monetary policy is effectively pushing on a string."


7. "Nearly 80% of money managers in Barron’s Big Money Poll say they are bearish on Treasuries. When everyone agrees that rates are headed higher, something else is bound to happen." As we here at Market Folly had posted up earlier, hedge funds had a record short position in 10 year treasuries, as illustrated below by Societe Generale:

(click to enlarge)

8. "Similarly, retail investors are once again, near their highest allocation to equities at the market’s highs. I believe some call this Predictably Irrational. The last time bullish sentiment was this high was back in December 2007 when the S&P 500 was trading at 1500!" Bespoke Investment Group had in the past put out a graphic showcasing extreme levels of bullish sentiment found below:

(click to enlarge)

Additionally, Pragmatic Capitalist charted out a survey of asset allocations that highlighted how everyone and their dog had moved out of cash and into stocks:

(click to enlarge)

9. "Greek default and contagion risks across the Eurozone periphery. Cascading disruptions throughout the European banking system. This risk will not go away anytime soon. News will get worse before it gets better. Think back to how subprime was “contained” or how the Bear Stearns rescue marked the “panic lows” for the markets. Greece is a pebble in the Euro Pond. The ripples it causes will ultimately be very messy."


10. "Read number nine again."


Specifically regarding the recent implications of Greek default, we want to highlight that just this morning we posted how Kyle Bass' hedge fund Hayman Advisors is very concerned about currency devaluation and inflation around the globe. There's an interesting dynamic here because while Broyhill thinks the events in Greece will cause investors to 'flock to safety' in bonds, Hayman Advisors believes these sovereign defaults will only lead to inflation. The difference between these two stances is that Broyhill's position is based on a near-term reactionary move by investors while Hayman's thesis is centered on a theoretical long-term consequence.

An intriguing and well thought out set of reasons for a wager on bonds from Chris Pavese at Broyhill. They've definitely made a contrarian wager here and until yields on the 10 year treasury break out of that multi-decade downtrend, you can't really argue with their position in the near-term. Only time will tell whether we ultimately have inflation or deflation. But that certainly hasn't stopped hedge funds and investors from placing bets in the mean time.

Overall though, we've seen the vast majority of hedgies anticipating inflation. Howard Marks of Oaktree Capital laid out ways to play inflation. East Coast Asset Management came to the same conclusion of an inflationary stance in their deflation-reflation continuum research. And again as we noted this morning, Kyle Bass is now anticipating currency devaluation around the globe.

However, we do make note of a few select firms that are notably bullish on bonds and reside in the deflationista camp, including Hugh Hendry of the Eclectica Fund. Indeed, this is what makes markets great: a never-ending difference of opinion. Perhaps a compromise of views would be deflation in the short-term followed by longer-term inflation. We'll have to wait and see. For a primer on how to position portfolios for either outcome, head to our previous post on investment scenarios for inflation versus deflation.

Why The Stock Market Is Up Over 70% From Its March 2009 Low

The following is a guest post from FirstAdopter.com, a site covering investing and consumer technology news:

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There’s a lot of conspiracy theories out there about how the government is manipulating the stock market upwards (I’m looking at you Zero Hedge) by buying stock futures, etc. However a light bulb went off in my head after I read this Time magazine interview with Pimco’s Bill Gross on how simple the explanation is.

But secondly, there’s a ripple affect. Just speaking about Pimco’s general portfolio strategy, we’ve sold our agency mortgage securities, Fannie and Freddie, in the billions to the willing check of the Fed. They’re buying a trillion dollars of them, or have over the past 9-12 months, and so we sold them a lot of ours. Now, what did we do with the money? We bought Treasuries, we bought corporate bonds, and so the bond markets in general have benefited, as have stocks because this available money effectively flows through the capital markets. So it’s a trillion-and-a-half dollar check that won’t be there as the Fed withdraws from the market. How that affects the markets, I just don’t know. I’m not eagerly anticipating the answer, but I think it holds some surprises in 2010, not just in mortgage securities but stocks as well.

So basically Bill Gross, the largest fund manager in the world, explains it to us. The Fed has been buying $1.5 trillion worth of securities from financial firms at unnatural supply/demand and some would say inflated prices, who then use this big pile of money they get from selling to the Fed to buy other stuff like corporate bonds and stocks. This is $1.5 trillion that did not exist before. It is printed money that is flowing through the financial capital markets lifting all boats. A simple explanation for the markets’ rise.

To prove this let’s look at the timing of Fed mortgage backed security buy program announcements. In 2008 the SP500 bottomed on November 21st, 2008. I remember things being very scary then. The Fed then announced their first $500 billion mortgage backed security (MBS) buy program on November 25th, 2008 (Link). The market then rallied 25%+ off the low and topped on January 6th, 2009.

The market then tanked again and bottomed on March 6th, 2009. I remember things being even scarier then. The Fed decided to add $750 billion to the MBS buy program to the original $500 billion and $300 billion of long-term Treasuries for a total over $1.5 trillion of buying power on March 18th, 2009 (Link). In time this $1.5 trillion of printed money worked its way through the system, hence the amazing 70%+ rally.

The lesson is the next time the Fed announces another $500 billion+ capital markets buy program buy the market hand-over-fist, although I doubt this will happen anytime soon given the political climate. And the $1.5 trillion of securities that the Fed bought? Here’s what Bill Gross says about that.

They won’t sell — it’s a near impossibility to unload what they’ve purchased over the past 12 months.

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The above was a guest post from FirstAdopter.com.

PIMCO's Bill Gross Bets On Deflation

Bond manager Bill Gross of PIMCO clearly feels deflation is still a threat. His actions speak louder than any words he might speak given that he has been buying long-term treasuries over the past few weeks. Gross now has 44% of his Total Return Fund's assets in government related bonds, which is the most since August 2004. Back only 3 months ago, Gross had only 25% of the fund in these assets. In doing so, PIMCO and Gross sold some of their mortgage debt.

This is a notable shift because Gross plowed the Total Return Fund's assets into corporate debt earlier in the year as he liked buying debt of companies that had deals with the government as he felt security there. While one could speculate that maybe Gross was just 'taking profits' in corporates as the easy money there has already been made, the force of his move into long term bonds speaks volumes and stamps down an emphatic deflationary viewpoint. Gross feels that there will be a flattening of the yield curve due to deleveraging, deglobalization, and regulation. Such a move in yields would constitute short-term rates rising while long-term rates fall. And as the name implies, this is the complete opposite of curve steepening. In the past, we've covered how numerous hedge funds have had a stark difference of opinion by putting curve steepener trades on. In particular, we just last week focused on hedge fund legend Julian Robertson's curve caps play. So, it's interesting to see the 'battle' here between deflation and inflation, and respectively Gross and Robertson.

In Bill Gross' September commentary, he draws a few conclusions upon which he can focus his strategy around. PIMCO essentially feels that global interest rates will remain low for an extended period of time while markets and economies recover. Drawing on that point, they think that the duration and extent of quantitative easing as well as stimulation efforts will be a crucial factor in determining investment returns. PIMCO likes to 'play on the government's team' in this regard as they favor exploring investments that will benefit or remain secure from government policies. They also think that the dollar will suffer over a longer timeline. Gross is counting on long-term rates coming down as assets are substituted for cash on the sidelines. Basically, he is betting that institutions will look to sell some reflated assets and use cash to take care of debt or refinancing. So, definitely interesting conclusions and you can read the rest of PIMCO's thoughts here. The main thing to take away though is the fact that Gross has a deflationary viewpoint and sees an emphasis being placed on delevering, deglobalization, and regulation.

For more from PIMCO and Bill Gross, you can read his September commentary here and his August commentary here. And for the other side of the argument, make sure you check out our piece on Julian Robertson's inflationary wager. The deflation versus inflation debate continues as more and more warriors enter the ring, placing their bets on the outcome. It certainly will be interesting to see who wins because there are always two sides to a trade. However, the intriguing thing here is that both sides could technically win if the participants are patient through the gyrations in their respective positions and choose ideal exit points as rates and the markets continue to shift. At this stage of the game, anything's possible in these crazy times.

Treasuries At Resistance (TLT Chart): Will the Trend Hold?

Kevin has recently brought a great chart to our attention. He pulls up the TLT which is essentially the 20 year treasury in exchange traded fund form. While some could argue technical analysis on this vehicle is a moot point, we still think there are some interesting observations at it has held numerous trendlines in the past.

This time around, Kevin has targeted $95 as the line in the sand for TLT. And, we completely agree with that. If you look at past trends for treasuries/bonds, you'll see that they typically put in a seasonal low around May or June. We are obviously right in the midst of that. What makes this interesting is that TLT is currently bumping up against its downward trendline (the red line), possibly set to breakout to the upside. This scenario would yet again solidify the seasonal aspects bonds have exhibited in the past. This might seem like mumbo-jumbo to some people, but it's still interesting to at least highlight.

(click to enlarge)

Currently, TLT is facing double resistance: from the downward trendline and also from the previous low established back in early May (the green horizontal line). So, watch this current area as a pivot point for the next big move in treasuries/bonds. If resistance holds, you can get short. If it breaks resistance, then get long for a trade. Either way, this vehicle often represents the inverse of the equity markets. So, a breakout in treasuries (people flocking to 'safety') would obviously be bad news for equities.

We saw this phenomenon in a big way back in October/November of last year. While it is unlikely we'd see that violent of a decrease in equities (and subsequent rise in TLT share price) again, the fact that numerous people have been calling for more downside is a cause for concern. This suspicion could possibly be confirmed if treasuries breakout to the upside. At the very least, it's an interesting indicator to monitor.

For additional thoughts regarding treasuries, make sure to check out hedge fund legend Julian Robertson's steepener swap play. That bet has sparked a lot of conversation in the debate as to which direction treasury yield curves are headed. Julian argues that they are headed 'steeper', while many others argue 'flatter' in a reversion to the mean trade. And, this is obviously very relevant because if TLT breaks out to the upside as hypothesized above, that would indicate the yield on the 20 year Treasury falling. (Remember, bonds have an inverse relationship between price and yield). Those betting on inflation and yields rising (by shorting TLT) have certainly had their way since the start of 2009; yields have risen and TLT has plummeted. Now it's time to see if the trend holds or not.

Julian Robertson's Steepener Swap Play (Shorting US Treasuries)

Simply put, Julian Robertson is the definition of a hedge fund legend. And, his success is noted by the fortune he has amassed as he now graces the Forbes' billionaire list. He has pioneered a successful investment methodology, he has generated outstanding returns at his famous hedge fund Tiger Management, and his influence has sprouted some of the most successful modern day hedge funds in the form of the 'Tiger Cubs.' And, most importantly, he predicted the financial crisis two and a half years ago in an interview with Value Investor Insight. When he talks, you listen.

For those unfamiliar with Robertson, we'd highly recommend checking out the profile/biography we just wrote on him this morning. In that piece, we have outlined exactly why you should follow him (and the Tiger Cubs for that matter too). As we detailed in his profile, Robertson has a unique investment methodology. He takes a macro approach, finds a smart idea, researches it exhaustively, and places a big bet. And, when he feels he is more than correct, he will 'bet the farm.' And, it looks like we have identified Robertson's next play where he has and will continue to 'bet the farm.'


Julian's Big Bet

Let's start by making one thing clear: this is not a new position for Robertson. He has been talking about different forms of this play for a while now. But, since he has so much conviction behind this bet, we figured it would be prudent to take a closer look. Not to mention, his interview with Value Investor Insight was just published and it again highlighted his thoughts on this play. Today, we are going to highlight Julian Robertson's steepener swap play. In layman's terms, he is betting on inflation. Taken from eFinancialNews, "Steepeners are a type of interest rate swap, where one party agrees to pay the other a fixed rate in exchange for a floating rate, which is derived from the difference between long and short term rates. Many of these products also use high leverage, where the difference between the two rates is multiplied by up to 50 times to produce a higher return."

He thinks rates could hit 7% easily and could go as high as 18%. We agree with him on this play and we first published our very basic rationale behind shorting US Treasuries back in October of last year. The main point we're focused on is the wager that inflation is in our future. If such an outcome came to fruition, yields on long-term Treasuries would rise. When the yields increase, bond prices will drop, thus benefiting the short position. While the vehicles noted in this article are all slightly different in construction and purpose, they all broadly wager on the same outcome: inflation. Julian's talked about this play in numerous forms, and we actually first heard about his 'curve steepener' play in January 2008 in Forbes. That piece highlighted how Robertson was "long the price of two-year Treasuries and short the price of the ten-year Treasury - betting that the difference, or curve, in the yield between the two will increase." Such a play is negative on the US economy and Robertson executed it because he felt the Federal Reserve would continue to flood the economy with money. And, he has been right.

What's fascinating here is that retail traders and investors could put on essentially the same play using the marvels of exchange traded funds. If you wanted to put a curve steepener play on by going long the 2 year Treasuries and shorting the 10 year Treasuries, you could simply buy SHY (iShares Barclays 1-3 year Treasury etf) and then short IEH (iShares Barclays 7-10 year Treasury etf). This is an easy way to put on the same trade Julian played at the beginning of 2008.

Robertson ultimately feels that the US dollar will become so weak that it causes the central banks of China and Japan to stop purchasing Treasuries. As such, 10-year bond prices would move down and that's exactly what we've seen play out. Back in January of 2008, Robertson told Fortune, "I've made a big bet on it. I really think I'm going to make 20 or 30 times on my money." Moving on from his curve steepener play, we then heard Julian talk about a 'steepener swap' play at a Tiger Cub hedge fund panel. At the panel, Robertson joked that last Christmas his family would have “a steepener in every stocking." This is definitely one of Robertson's token 'bet the farm' plays if there ever was one.

In his recent interview with Value Investor Insight, Robertson lays out further rationale for his play. He says, "I'm amazed at the amount of money the government is throwing at this thing. You don't even react anymore unless somebody's talking about $1 trillion. I genuinely admire the administration's courage in doing what it's doing, but not the wisdom of it. I look at the TALF (Term Asset-Backed Securities Loan Facility) program, for example, and it's almost a bribe to get people to put on more leverage ... I ask anyone to give me an example of an economy beefed up by huge amounts of quantitative easing that did not inflate tremendously when or if the economy improved. I think what we're doing now will either fail, or it will result in unbelievably high inflation - and tragically, maybe both. That would mean a depression and explosive inflation, which is frightening."

While it may be frightening, it seems to be the scenario that Robertson is wagering on. After all, his steepener swap play will shower him with profits if rampant inflation rears its ugly head. He thinks that the US has not solved the current problems and things could go from bad to really bad. He likened the U.S.'s current situation to that of Japan in 1989, but thinks we are in far worse shape.


Notable Investors Bearish on US Treasuries

Robertson is most certainly not alone in his views. Numerous other prominent investors and hedge fund legends share his distaste for treasuries. We just recently noted that Michael Steinhardt says treasuries are a foolish play over the long term. He categorizes them as risky, noting that the yields are low and the danger is high. Steinhardt of course ran one of the first truly successful hedge funds (Steinhardt Management), garnering a 23% return each year for almost thirty years.

Additionally, acclaimed investor Jim Rogers also wants to short government bonds. Rogers is well-known for his stellar returns while managing the Quantum Fund (now defunct) with then partner George Soros. Rogers expects the government to buy Treasuries in an effort to stem borrowing costs. Rogers says that since Governments around the world are printing a ton of money and borrowing insane amounts that he almost has no choice but to short them. Rogers had previously been short the Treasuries, but covered them for the near-term in favor of waiting for another opportunity to short, as we noted when reviewing Rogers' portfolio. We could add even more talented investing names to this list, but suffice it to say that there is a confluence of smart minds all marching to the same beat.

When such a confluence of smart minds all wager on essentially the same thing (inflation), you should probably turn your head at the very least.


How To Play It

Now that we've seen so many smart minds interested in this wager, how do we play it? There are essentially a few different ways to place a bet on inflation similar to that which Robertson has made. The vehicles referenced earlier are not typically available to retail investors and traders. As such, we'll focus on ways that non-institutional players can protect themselves from inflation. Additionally, we'll take a quick look at the complex vehicles for those working at institutions with access to such products.

Exchange Traded Funds (ETFs) / Mutual Funds

The simplest way for retail investors and traders to bet on inflation is to bet against US treasuries by shorting them. Currently, there are a few ways you can do this. There are two exchange traded funds (ETFs) currently offered which index long-term treasury bonds. Ticker TLT is the iShares Barclays 20+ year treasury fund. Its performance corresponds to the price and yield of the long-term treasury market. As such, investors and traders who wish to bet on inflation (and against treasuries) can simply short TLT. Also, those who wish to play the 7-10 year Treasuries can do so via iShares Barclays Treasury index etf IEF. That vehicle corresponds to the price and yield performance of the intermediate term sector of Treasuries.

Additionally, you could also buy put options (LEAPs) on this index if you were so inclined. Buying puts on TLT is essentially the same bet as shorting TLT outright. We are not necessarily recommending using options to execute this play because of the leverage they employ, the time decay that moves against you, and the fact that we're not big fans of LEAPs to begin with. And, let's face it, such a large bet on inflation could take years to play out. As such, you're pretty much forced to use LEAPs if you wish to execute this play via options.

There is also another exchange traded fund currently out that 'ultrashorts' the treasury market. Its ticker is TBT and it is 2x the inverse of the TLT vehicle we just mentioned. However, there is one huge caveat with this play. Ultrashort ETFs reset on a daily basis and suffer compounding errors over time and noticeably more volatility. So, the longer you hold them, the more your results skew from the index they are supposed to be tracking. And, that is not something you want to experience when placing a longer-term bet on treasuries. Consider that over the past 1 year timeframe, TLT is up 1.43%. Theoretically, since TBT is 2x the inverse of TLT, TBT should be -2.86% over the same timeframe, right? Wrong. As you can see from the chart below, over the same time frame, TBT is actually -24.37% and has not tracked its index accurately over time at all whatsoever.

(click to enlarge)

This is why you should avoid using TBT for anything besides daily trades. There have been numerous articles published on this subject, and we recommend avoiding ultrashort ETFs. Additionally, since TBT employs leverage, it carries more risk. For the retail investor or trader, simply shorting TLT seems to be the best and easiest option at this point in time.

Investors also have the option of using the Rydex Inverse Government Bond Strategy mutual fund (RYJUX). This mutual fund has an expense ratio of 1.4% and essentially is the same as shorting TLT outright without leverage. RYJUX is a 1x short of 30-year Treasuries and is another option for investors who don't mind slightly less liquid mutual funds.

Lastly, while unrelated to the plays Julian Robertson has referenced, investors also have another option to protect themselves from inflation. Buying Treasury Inflation Protected Securities (TIPS) is an easy option that can be done via another exchange traded fund, TIP. This iShares Barclays etf is a bond fund that tracks the price and yield of the inflation-protected sector of the US Treasury market and is another vehicle that helps shield you.


Steepener Swaps / Constant Maturity Swap (CMS) Rate Cap

Now we'll turn our focus to the specific investment vehicle Julian has referenced. The vehicle is called a steepener swap and it is typically reserved for institutional investors.

In his recent interview with Value Investing Insight for May/June 2009, Julian Robertson says, "The insurance policy I would buy is called a CMS [Constant Maturity Swap] Rate Cap, which is the equivalent of buying puts on long-term Treasuries. If inflation happens the way it could, long-term Treasuries are just going to explode. Less than 30 years ago, long-term interest rates got to 20%. I can envision that seeming like a very low interest rate compared to what might occur in the future."

Option ARMageddon has also posted up a nice explanation of the vehicle courtesy of Tiger trader Pat O'Meara. They note that these are options to bet on interest rates rising for 10-year or 30-year treasuries. Option ARMageddon writes, "(Tiger trader Pat O'Meara) provides a current example, in which one could buy for $50,000 a five-year option, betting that the yield on $10 million worth of 10-year Treasuries rises above 4.2% between now and expiration in 2014. Including the 0.5% cost of the option, the break-even yield level is 4.7%." So, the vehicle is slightly more complex and definitely an institutional type of wager.


Other Inflationary Wagers

While Julian certainly thinks inflation is in our future, he is hesitant to buy gold. In the Value Investor Insight interview, he goes on to say that, "I've never been particularly comfortable with gold as an investment. Once it's discovered none of it is used up, to the point where they take it out of cadavers' mouths. It's less a supply/demand situation and more a psychological one - better a psychiatrist to invest in gold than me." While his argument makes sense, we found it intriguing seeing that we have tracked numerous prominent hedge fund managers moving into gold here on the blog.

Robertson's former colleague Stephen Mandel of Lone Pine Capital has a large call position on the Gold etf GLD. Additionally, respected hedge fund managers such as David Einhorn of Greenlight Capital, Eric Mindich of Eton Park Capital, and John Paulson of Paulson & Co all have sizable gold (and gold miner) positions. While Robertson doesn't like gold as an inflation play, he does have a few other recommendations. He likes natural resource stocks and then also says, "Zinc would also seem to me to be a very good inflation hedge."


Precautionary Note

While we have finally gotten around to writing a follow-up to our initial treasuries post, we do want to insert a note of caution. Year to date for 2009, treasuries are already down over 23%.

(click to enlarge)

The sudden and rapid decline is most likely due for a correction and we do not feel that the current time is ideal to initiate a position in shorting Treasuries. We would look for any sign of a rebound before putting on a new short position. That said, we still feel the move in treasuries will take many years to fully play out and this is a very long-term inflationary bet. While short-term moves like the one we've seen this year are nice, the full extent of the move could take years to come to fruition. We consider the publication of our post on this topic to be a contrarian indicator. After all, when there are headlines saying for you to get into something after a big move has already taken place, it's time to at least take some profits. So, place your bets with caution, as you'll have plenty of time before inflation truly rears its ugly head.

If you believe inflation is in our future, then 'bet the farm' with Robertson by buying steepener swaps, shorting US Treasuries, or buying puts on long-term Treasuries (whichever you have access to). As infomercials for rotisserie cookers like to enthusiastically exclaim, just 'set it and forget it.'

Hedge Fund Legend Michael Steinhardt Says Treasuries Are Foolish

The legendary hedge fund manager Michael Steinhardt has recently voiced his distaste for Treasuries over the long-term. In a recent Bloomberg television interview, he said, "To be a long-term investor in Treasuries at this point I think is foolish. The rates are low, and the danger is high." If you're unfamiliar with Steinhardt, he ran one of the first truly successful hedge funds, garnering a 20% return each year for almost thirty years. His Steinhardt Management Co, which he opened in 1967, earned 24% a year for multiple decades. He truly is a successful hedge fund manager with a proven long-term track record.

And, with that in mind, it's interesting to see that Steinhardt has joined numerous other well-tenured investors in his dislike of treasuries. He thinks that government bonds are not safe investments and shares Jim Rogers viewpoints on this subject. Rogers, of course, has a solid background as well, having run the successful Quantum fund with ex-partner George Soros. So, we now see that both Steinhardt and Rogers see Treasuries as poor investments for the future, as we noted in our Jim Rogers portfolio update. In the past, we here at Market Folly have even gone as far to lay out the rationale behind shorting treasuries. (That play has picked up steam as of late and we still need to do a follow-up post on that subject).

Steinhardt goes on to say that he thinks the current market rally will not last and that we are not out of the woods yet. He says, "The economy is still a scary place. My net feeling is that this rally doesn't have all that much more to go and the dangers out there remain consequential." Clearly he sees this as a bear market rally and thinks we have large fundamental problems still unsolved.

Nowadays, Steinhardt is the chairman of WisdomTree Investments, a firm that creates exchange traded funds (ETFs). Steinhardt also has an autobiography out entitled No Bull. It is a fascinating read detailing the life of one of the first true hedge fund managers out there, as his firm survived the collapse of the 1960's. This book also recently appeared on hedge fund Blue Ridge Capital's suggested reading list, in their biographical/historical category. We'll continue to track Steinhardt's words of wisdom whenever he makes a sporadic appearance.

Peter Schiff Talks Treasury Bubble

Peter Schiff is out with a piece discussing treasuries, entitled 'The Fed's Bubble Trouble.' Here are some of his thoughts:

"If it is well known that Fed will be a big purchaser of Treasuries, those buying now will be positioned to unload their holdings when the buying spree begins. If the Fed pays higher prices in the future, traders can earn riskless speculative profits. If the traders lever up their positions, as many are likely doing, even small profits can turn unto huge windfalls.



The downside of course, is that all of the demand for Treasuries is artificial. Treasuries are now in the hands of speculators looking to sell, not investors looking to hold. These players are analogous to the mid-decade condo-flippers who flocked to new developments for quick profits. They did not intend to occupy their properties, but rather flip them to future buyers. Once these properties came back on the market, condo prices collapsed, as developers were forced to compete for new sales with their former customers.



This is precisely what will happen with Treasuries. Just as the U.S. government issues mountains of new debt to finance the multi-trillion annual deficits planned by the Obama Administration, speculative holders of existing debt will be offering their bonds for sale as well. In order to prevent a complete collapse in the bond prices the Fed will be forced to significantly increase its buying.



However, since the only way the Fed can buy bonds is by printing money, the more bonds they buy the more inflation they will create. As inflation diminishes the investment value of low-yielding Treasuries, such a scenario will kick off a downward spiral. But the more active the Fed becomes in their quest to prop up bond prices, the bigger the incentive to hit the Fed?s bid. The result will be that all Treasuries sold will be purchased by the Fed. But with the resulting frenzy in the Treasury market, and with inflation kicking into high gear, we can expect that demand for other debt classes that the Fed is not backstopping, such as corporate, municipal and agency debt, to fall through the floor, pushing up interest rates across the board."

You can catch the rest of his thoughts here. Also, although we're in no big hurry to put on the full position, make sure to read our rationale behind shorting treasuries.

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.

Treasuries

Gregor Macdonald has a great post up detailing an issue I've been mulling over myself: the flooding of the market with supply of treasuries. He writes,

"My view is that because current events in equity and credit markets are so dramatic, the market has not yet paid attention to the coming boundary, of debt-ology. However, I expect participants to direct their thinking this way quickly, once the intensity of the crisis lessens. I see two areas, where markets will inevitably focus.

First, The FED could be getting close to more unconventional measures, like direct buying of long-dated Treasuries to bring long-rates down. Second, the quantity of new Treasury issuance, both in train and intended, is so gargantuan that it’s not clear how the world would be able to actually take up the supply. There may be structural limitations. Simply put, it’s not clear there’s enough available capital in the world to increase the US debt position further. After all, we have already been sucking up the world’s savings for most of this decade. It strikes me the only method to ensure this new supply is taken up would be that other central banks would eventually have to monetize the USA, in the same way the USA is monetizing its own banking system. So future Treasury issuance may depend either on our own central bank to monetize it, or for foreign central banks to do the same. When either happens, I’m of the opinion it’s Game Over."

You can check out the rest of his post on the subject here. I mainy posted this up as food for thought and for a way to possibly play this impending situation. Over on Twitter, many of us finance/market junkies have been discussing tickers PST and TBT. PST is the etf for Ultra Short the 7-10 year treasury, and TBT is the etf for Ultra Short the 20+ year treasury. A few months ago, these vehicles didn't even exist. And, as of 2 weeks ago, I am long TBT. The consensus was that longer term maturity paper was a better short. Monitoring technical analysis on this name doesn't necessarily make a whole lot of sense given what it is, but I have noticed that the etf itself has seen support around $56/57 and resistance around $65, as noted in the chart below. Either way, I think this is a great longer-term play based on what we've seen lately in the supply of treasuries.

(click to enlarge)

I've posted regarding Gregor's writings before and would definitely suggest everyone check his blog out for some great insight into energy and other topics.