I'm Going Long TBT

've been watching Treasury yields for a while, looking for a sign that the bubble has burst. It looks to me like it might have. I'm certainly late to the party, as the Ultra Short Lehman 20yr+ ETF (TBT) is up considerably from its lows. However, I think it has far to go up, and the downside risk appears limited. This doesn't mean that it won't reverse course, but I think over the longer term (despite my misgivings about leveraged ETFs), it will do very well.

First some numbers.

The current US public debt outstanding is just over $10.7 trillion.

As of November 2008, major foreign holders of Treasury securities own around $3.0859 trillion in US government debt. The top five are

China $681.9 billion
Japan $577.1 billion
UK $360 billion
Caribean Banking Centers (Bahamas, Bermuda, Cayman Islands, Netherlands Antilles and Panama) $220.8 billion
Oil Exporters (Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria) $198 billion.

The principal reason that these foreign holders have been able to buy so many US bonds was the virtuous circle created by US consumers buying foreign goods and raw materials and shipping US dollars overseas, the proceeds of which were used to buy US bonds (and mortgages, etc). We bought their junk and oil, and they bought our debt. As everyone by now knows, the circle appears to be breaking, perhaps turning into a downward (death) spiral. Despite government calls for people to borrow and spend, consumers are actually starting to save.

The Japanese economy is facing a severe decline. It is expected to contract 2.5% in 2009, according to the IMF. A former Bank of Japan official is more pessimistic, expecting a decline of at least 3.8%. This will be on top of the 10% or more annualized decline in GDP in the final months of 2008 (expected, figures not available yet--the average estimate is for an annualized late 2008 GDP drop of 11.5%). Add to this political turmoil. Japan will probably be a less willing/able bond buyer. It has already reduced its US bond holdings ($582 billion in October 2008).

The United Kingdom's GDP fell 1.5% (a downward revision is expected) in the fourth quarter of 2008. The expectation for this year is a drop of 3%. With the pound falling and some currency experts calling for parity with the dollar, the UK probably won't be able to buy as many US bonds.

China, the world's 3rd largest economy (sorry Germany), is also facing problems. Its GDP is expected to grow at 7% in 2009. This is terrible for a country that requires 15 million new jobs annually just to keep up with population growth. China has already complained about the low bond yields, and has been angered by Geitner's currency manipulation comments. It's now likelier that China will start selling its US bond holdings instead of buying more.

Oil prices have come down a long way, leaving bond buyers like Saudi Arabia with far less cash to spend. Faced with a worldwide economic decline, other major bond buyers will also have less money to invest.

The US bond buying activities of the top foreign bond purchasers, then, should be curbed. With less buying interest from a major portion of the market, it seems that Treasury yields will have to go up. Add to this increasing supply.

According to Bloomberg:

The government will need to auction $493 billion in debt this quarter, 34 percent more than initially projected, the Treasury said on Feb. 2. It will probably borrow as much as $2.5 trillion during the fiscal year ending Sept. 30, compared with $892 billion in notes and bonds it sold the prior 12 months, according to primary dealer Goldman Sachs Group Inc.

Who is going to buy all this debt? As we saw, the major foreign holders may not be as willing or able. Other market participants, will sooner rather than later demand higher yields before they start buying. While yields are up from their troughs, they are still very high historically. Barring another panic like we had in December, rates should not fall very much, if they do at all. (It's certainly possible that 30 year yields can fall to 0% in a super panic, but it is far more likely that they will continue rising. Also, if something like a 0% yield on the 30 year happens, we are royally screwed.)

The buyer of last resort is the Fed (which Marc Faber says follows the "Zimbabwe School" of economic thought). As they print money, they can buy as much debt as they want. If the bond market balks, the Fed will try to pick up the slack. The Central Bank can win a few early battles, but the market will win the war, as it always does. The more the Fed prints, the sooner the dollar's demise. If the Fed has to step in because other buyers are unwilling, those buyers will not be any more willing when the number of dollars increases. Interest rates will have to rise.

If/when interest rates rise, the economy will stagnate further. Consumers will spend less on foreign goods, which will leave less money for foreign bond purchases. Less bond demand (and ever more supply) will make rates go up even higher. We will eventually have inflation, as the Fed prints more money--more upward pressure on interest rates.

We can have inflation even if the economy continues to struggle. The Consumer Price Index was just under an annual rate of 15% in the late 1970s. They called it stagflation. The 30 year Treasury yield, which was around 8% at the end of the 1970s spiked to over 15% in 1981. It's hard to see why something similar will not repeat again.

The 30 year Treasury yield, at the time of writing, is at 3.683%. Let's say it goes back to 4.5% (the 52 week high is 4.813%) in the next few months. That's a loss of around 18.5% for the 30 year Treasury price. As TBT is twice the inverse, we can expect a gain of around 37% or more (as long as there isn't too much volatility). Over the longer term, if the US continues its massive borrowing, which it probably will, the yield can go a lot higher.

Note that if yields fall, the TBT will fall twice as much. Should the fall be significant, the expectation of a 37%+ gain if the 30 year yield is at 4.5% will have to be reduced. Example: the 30 year Treasury yield falls 10%, and then rises 11%. It's back to where it started. In this scenario TBT will fall around 20% and then will rise around 22%. It won't be back where it started. It will be down 2.6%.

I'm going long TBT. If it falls (which it might), I'll buy some more. One major caveat here is that this trade seems like such a no brainer that it's bound to go wrong somehow. Easy money is always the hardest, as they say. If you're following me into TBT (hopefully you're already in it in from the low 40s or mid 30s), don't put everything into it. And please do your own research.

Other ways to play this, as mentioned before at the last market peak, are to short the long 20 yr+ Treasury ETF (TLT), buy puts or sell calls on TLT, or buy calls or sell puts on TBT.

Another way is to sell puts or buy calls on the 30 year Treasury index. These are cash settled. If you are long the option at expiration and it is in the money, you are paid the difference between the yield and the strike price. If you are short an in the money option at expiration you pay the difference between the yield and the strike price. If you are long an out of the money option at expiration, you lose your premium. If you are short an out of the money option at expiration, you get to keep your premium. If the strike prices are puzzling in the Yahoo! link, multiply the yield by 10 (e.g., 3.683% = 36.83).

If you are long Treasury bonds, think about using some of these to hedge yourself.

And of course, if you think Treasury yields are going down, do the opposite--short TBT, go long TLT, etc.

Update 2/10/09:

Links to WSJ charts comparing S&P/DJIA and 30 year yield:

For an opposing view, check out this article at thestreet.com, which says that the bubble is in TBT, not treasuries.

Disclosure: I hold no positions in the above mentioned securities, but am planning to go long TBT.

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