Going Down

For the first time in 2009 I actually purchased something to capture a changing market environment. Having stayed on the sidelines for all of the past year ( I did not sell during the crisis and did not buy during the recovery as neither one made sense to me), I decided to act. I took a long position in TBT, an ETF which gives double short exposure to the long end of the treasury curve. It is not a perfect short play on the long end of the treasury curve. TBT corresponds to twice the daily movement of the Barclays Capital 20+ Year U.S. Treasury index. However, it is an affordable way to speculate (emphasis on speculate) on rising rates on the long end of the curve. After all, I am not a man of such eminence to be able to short U.S. treasuries.

At first glance it may appear that I have changed my tune and am now predicting a blow out of long-term rates. That is not the case. I am merely predicting that long-term rates cannot stay this low forever. I would be thrilled if by this time next year the yield of the 30-year government bond is over 5.00% and the 10-year treasury note yield is over 4.00%. In fact 100 basis points may be the extent of the rise we see in the next year or two (possibly for the entire cycle).

Why do I think that the rise of long-term rates will be limited? The economy is just not that strong and economic activity, consumer activity, will not reach levels seen during the past two decades with more traditional lending standards. In fact, I think the economy will stumble somewhat during the next two quarters. What I am saying is counterintuitive I know, but markets are not behaving logically. We have gold and stocks being used as dollar hedges fueled by cheap leverage. As soon as the Fed removes its extensive stimulus and borrowing costs rise for traders, trades will begin to unwind. As short-term rates rise the U.S. dollar will strengthen as investors begin to buy on the short end of the curve at new higher rates. As the dollar strengthens, the need for dollar hedges diminishes causing a further selloff of gold, equities and junk bonds. The strengthening dollar reduces, but not eliminates the need for foreign central banks to buy long-term treasuries to manage their currencies. That is where the mild rise in long-term rates comes from.

When discussing this strategy and theory with a colleague he asked where the money that is currently invested in stocks, junk bonds and gold going to go? The answer is back to the lenders. The great rally of 2009 is mostly due to speculating with borrowed money. The Fed hopes that the economy can catch up to the equity markets and a correction will be avoided or dampened. This is the holiday season and maybe Mr. Bernanke's wish will be granted.