Monday, October 18, 2010

The Next Big Short: U.S. Treasury Bonds

I have written numerous times that you will be able make a career out of shorting Treasury bonds over the current decade. Eric Englund concurs. His analysis of the bond market situation is spot on:

After reading Michael Lewis’ wonderful book The Big Short: Inside the Doomsday Machine, I recommended it to a friend. As my friend is a financial professional, I knew he would enjoy a book about how a few obscure hedge fund managers, and their clients, handsomely profited from the collapse of America’s subprime-mortgage market. This friend knew that, starting in June of 2005, I had written extensively about the United States’ housing bubble (see articles, here, here, here, here, here, here, and here). So the meltdown in the subprime-mortgage market came as no surprise to either of us; but it definitely caught Wall Street by surprise. Upon finishing the aforementioned book, my friend called me and asked a thought-provoking, two-part question: "What is the next big short and how do we profit from it?"

Sovereign debt certainly has been in the financial headlines in 2010; with Greece getting the lion’s share of attention. In the midst of Greece’s debt crisis, Standard & Poor’s downgraded Greece’s credit rating to "junk" status. S&P’s rationale for this rating reduction was straight forward: "The downgrade results from our updated assessment of the political, economic and budgetary conditions that the Greek government faces in its efforts to put the public debt burden onto a sustained downward trajectory." What is not stated by S&P is that by joining the European Union, Greece no longer has its own central bank so it can’t paper over its debt crisis by printing more money.

Conversely, the United States’ central bank loves to use its printing press and is actively purchasing U.S. Treasury bonds with the objectives of keeping interest rates low and spurring economic growth in the U.S.; which will not work. As of October 15, 2010, a 30-year Treasury bond was yielding 3.98%. In addition to the Federal Reserve’s monetizing of Uncle Sam’s debt, such a low yield has also come about as individuals and large institutions, including banks, perceive U.S. Treasuries to be a safe haven; hence they are lending to this "AAA" rated borrower in droves. As George Goncalves stated: "Treasury bonds are gaining ‘rock star’ status…" Considering the heady levels the bond market has attained, is it possible that a bond bubble has emerged in the United States?

Egon von Greyerz, of Matterhorn Asset Management, certainly thinks so. He believes, indeed, there is a bond bubble of global proportions. Here is what he stated in a recent article:

The bond market is the biggest bubble in financial markets worldwide, in our opinion. Investors around the world are worried about the state of financial markets and therefore believe that government bonds represent a safe haven. These investors will receive the most enormous shock on two accounts. Firstly, no government will be able to repay the debts outstanding. So there will either be government defaults, moratoria, or money printing that totally destroys the value of the bonds. Secondly, interest rates are likely to go up significantly to at least 10–15%, totally destroying the value of the bonds.
Financial-market luminaries, such as Marc Faber, Jim Rogers, and Peter Schiff do believe U.S. Treasury bonds are in a bubble. In fact, in this interview, Jim Rogers states he is considering shorting U.S. Treasury bonds. If Rogers is thinking about shorting bonds, you should too.

Presently, I do hold a short position pertaining to U.S. Treasury bonds. I have taken this position via an inverse bond fund. Here is a description of this mutual fund:

The investment seeks total return, before expenses and costs, that inversely correlates to the price movements of Long Treasury bonds. The fund employs, as its investment strategy, a program of engaging in short sales and investing to a significant extent in derivative instruments, which primarily consist of futures contracts, interest rate swaps, and options on securities and futures contracts. It invests at least 80% of net assets in financial instruments with economic characteristics that should perform opposite to fixed-income securities issued by the U.S. government.
I did not take this short position without undertaking appropriate research. In January of 2005, LRC published my essay titled Should the US Government’s Sovereign Credit Rating be Downgraded to Junk? Here we are, over five years later, and Uncle Sam’s financial condition is much "junkier."

When I wrote the above-mentioned essay, the U.S. Government’s balance sheet revealed a deficit net worth of over $7.7 trillion. As of fiscal year-end September 30, 2009, the U.S. Treasury is reporting that Uncle Sam’s net worth is a mind-numbing deficit $11.5 trillion – I have included the 2009 balance sheet, below, for your viewing displeasure.

Read the rest here.


  1. There are several ETF's that you can do the same thing with as well without the tax drag that comes from a mutual fund (esp one that generates short term gains).

    One has to understand that shorting the long bond is akin to betting against the house in 'Vegas. Not that you can't win, but that the odds are stacked heavily against you. What you are really betting on is that the Fed will reach a point where it is no longer able to manipulate the long rates via its purchases. Since the Fed technically has no shortage of cash, it may take a long, long time for this to happen. My belief is that those buying long bonds know this and thus believe that the fed will protect their interests.

  2. What happens if you are right? The fed continues to devalue the dollar, the bond bubble eventually pops, and you get paid off in... devalued dollars. Or are you thinking that they peg the dollar to gold by then?

  3. Is the mutual fund he mentioned the best way to short long term treasury bonds? I was looking at ipaths dlbs etn, but haven't read a lot about it yet. Anyone else shorting treasuries now?