Macro Tsimmis

intelligently hedged investment

BUY ProShares UltraShort 20+ Year Treasury (TBT)

Posted by intelledgement on Wed, 21 Jan 09

Two of the least widely expected symptoms of the financial crash we are living through have been the comeback of the dollar and the increased popularity of U.S. government-issued debt.

We had deflation in the Great Depression, and deflationary pressures in circumstances where spending and employment are steeply declining are not surprising per se. When demand goes down, prices decline; it is a Economics 101. However, in the face of all the liquidity the Fed has injected into the system in an effort to keep credit available, seeing the dollar rally against all major currencies—and, in the midst of a financial crisis, gold decline in value as measured by dollars—is…well…cognitively dissonant.

Even stranger is the buying panic that has assaulted debt issues from the U. S. Treasury. The interest rate has declined steadily, actually hitting 0% last month (yep, the U. S. government borrowed $30 billion for 28 days for free!), as institutions looked for a safe haven to park funds. In fact the sale of three-month bonds on 8 December went off at 0.005% interest—the lowest ever—and was oversubscribed. The winners of the auction were able to resell the bonds on the secondary market at negative interest! (Yep, folks were willing to surrender some principal for the chance to have their money “safe” for three months.)

Check out this chart showing the relative performance of 20-year treasuries, the dollar, and gold since last July. (To see the same chart we are looking at, click on the link and then change the “From” date from today’s date to 16 Jul 08 and the “To” date from today to 21 Jan 09…unless of course today is 21 Jan 09, in which case you can ignore that last instruction.) Since last July, treasuries are up 26% (remember when the interest rate goes down, the value of the bond goes up), the dollar is up 17%, and gold is down 10%.

We still think there is more deflation coming, in response to more unemployment and demand destruction, not to mention the continued release of over-pressurized air from the still-deflating housing bubble. However, we are not so sanguine about the prospects for U.S. Treasuries. With the coming stimulus package on top of whatever additional emergencies arise, not to mention the steady drumbeat of debt financing and “normal” deficit government spending—which will be worse than normal with increased unemployment insurance and decrease tax revenues—we expect the supply of treasury debt issues to rise from here. And we expect the supply of willing borrowers to decline, because foreign (especially Chinese) dollar surplus funds are likely to be allocated to (their own) domestic stimulus activities.

We think this demand is likely to be particularly soft for longer-term debt instruments—such as the 20-year bonds—because while deflationary pressures are likely to keep short term bonds safe (in the sense that the dollars you get back in 28 days or three months will still be worth the same or perhaps even a tad more), it is hard to see how five or more years out inflation won’t be a factor. Consequently, we are buying the ProShares UltraShort 20+ Year Treasury ETF (TBT) here. The managers of this ETF seek daily investment results, before fees and expenses and interest income earned on cash and financial instruments, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Index. Thus it is a mirror image of the TLT fund we cited above in the chart, and has declined 42% since last July. (OK, not a mathematically perfect mirror image.)

If we are right, and the market is going to demand increased interest rates for longer-term Treasury issues going forward from here, then the value of outstanding longer-term Treasury bonds will decline, and the value of shares in this fund will appreciate.

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