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Another Bubble In the Making

Published on December 29, 2008

Another Bubble In the Making

December 29, 2008

In recent past, we have gone through a lot of bubbles; Dot.com, Property, Housing, Free money (aka Credit) led boom, Commodities and Shipping to name a few. The interesting thing is that when something goes up, we think that there is a perpetual fuel inside the rocket that will continue to lift it forever. And when it start to lick dust, we think of those “rockets” as poor pigeons waiting to be adopted, if ever. But what goes “abnormally up” has to come down to follow its natural path. Here is another bubble, if I may say so-

Few weeks back the FED established a new target range for the federal funds rate of 0 to 0.25% and also hinted on buying long-term treasuries. I think treasury bond prices have been pushed to similar bubble patterns as it was in commodities, or Tech. Well I am not going to put fancy charts to explain that but look at the attached two simple charts, one for Crude Oil and another one for the 30 year treasuries. Crude oil is generall more speculative, and Treasuries in a way should be rather less speculative due to their fixed and known payments but the exponential rise without correction raises concerns.

First some theoretical perspective-
30 Yr Bonds- Suppose you buy a 30-year Treasury bond at today’s market price — it yields 2.60%. That means for every $100 you invest, you get $2.60 each year in interest for 30 years. Such lowly yields represent the case of “Deflation” or call it fear of “Depression” that many are comparing the current crisis with. 2.6%! Not a wonderful returns, but at least it’s safe — isn’t it?

Who would sell such a miserable investment? The US government and why won’t they when there are plenty of buyers (currently). And who was/is buying it? The Foreign holders funding US consumption and now also the generally scared investing public that would like to safeguard the money (aka The Dollar) expecting to get back at least the same dollar amount (it’s different story that by that time, the dollar bill may not be of the same value)

Here are key points to note-

  • Upcoming inflation (may not be so soon though)! The same thing for which Fed is fighting for and is literally throwing money from helicopters. Central Bankers as well as government around the world are fighting in a co-ordinated effort to win over deflation and this “almost free money” will start to show results via inflation sometimes late 2009 or early to mid 2010 bringing real returns of 30-Yrs into negative territory and when combined with taxes, treasuries at current prices/yields doesn’t really spell for excellent long term investment.
  • Why did the yield drop so much in such a short time? Because the money has been parked into safe-heaven for general investing class and foreign holders have been buying treasuries to keep $$ high and fuel US consumption. Now the big treasury buyers themselves are finding low growth/recession in their own lands as well as they know they are facing probable losses either due to a) lower yields or b) lower value dollar. The US govt will have tough time to source more “foreign capital” without offering competitive yields which essentially means lower prices.
  • As the markets starts to stabilize, fund managers, money managers, retail investors will probably be taking out money from treasuries so as “not to miss” the recovery in other “riskier” classes aka stock market or other higher yielding but relatively riskier grade bonds.

Albeit, the Yield may go even lower from they are today, but for the above key reasons, I am beginning to be bearish on long term US treasuries. And for my bearish positions to be fruitful, money just has to flow out of treasuries. I don’t really have to bother which asset class it goes to as long as it leaves treasuries.

Just like other bubbles, I don’t know “WHEN” will it burst and therefore I am keeping my plans to hold, if needed, for rather a relatively longer time frame. If anything happens before that, that’s a bonus. If you do decide to follow this philosophy, pls do you due diligence and also make a habit to hedge your positions, so you have a chance to preserve capital even if you are wrong.

There are lots of ways to short Treasury bonds. You can do it directly, by selling actual securities short. Or you can short shares of a convenient exchange traded fund — the iShares Barclays 20+ Year Treasury Bond Fund (TLT). Or you can short Treasury futures contracts — or sell calls (or buy puts) on Treasury futures contracts.

  • Here are some underlying which are optionable -TLT, IEF, SHY, BIL, ITE, TLO, TBT
  • Here are some underlying which are not optionable-TLH, IEI, SHV, PLW, PST, EDV

There are two mutual funds designed to go up when Treasury bonds go down — the Rydex Juno Fund (RYJUX) or the Rising Rates Opportunity ProFund (RRPIX), but these are not optionable.

Those who are OPNewsletter subscriber, pls wait for my e-mail on the forum to know how I plan to play this.

Disclaimer– As of this writing, I don’t have either long/short positions in US treasuries yet. I may get into one any time and change my view depending upon market action. Pls do your due dilligence before investing and keep a risk management plan in case the trade goes against your plan.

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