PIMCO Admits: Betting Against Treasurys Was a Mistake

I have been consistently bullish on US Treasurys.

PIMCO now says that betting against US debt was a mistake:

Showing a more bearish view on the U.S. economy, Gross said PIMCO had initially dumped all of its U.S. debt holdings in March as he expected economic growth to be higher, resulting in inflation down the road.

That decision greatly undermined the performance of PIMCO’s Total Return Fund. As Treasuries prices rallied, the fund lost 0.97 percent in the past four weeks, while the benchmark Barclay’s U.S. Aggregated Bond Index rose 0.23 percent in the same period, according to Lipper data.

So far this year, the fund has returned 3.29 percent, less than the 4.55 percent recorded by the Barclay’s benchmark index.

“When you’re underperforming the index, you go home at night and cry in your beer,” the Financial Times, in its online edition, quoted Gross as saying. “It’s not fun, but who said this business should be fun. We’re too well paid to hang our heads and say boo hoo.”

Gross, who oversees $1.2 trillion at PIMCO, said it was “pretty obvious” he wishes he had more Treasuries in his portfolio right now.

Like I’ve said many times before, I think Treasury yields will stay low for much longer than people expect. Global flight to safety, over indebtedness, credit deflation or rather outright deflation, recessions, depressions … all these are bullish for cash and near-cash assets (of the world’s reserve currency), such as Treasury Bonds/Notes/Bills, and of course the mother of all cash … gold.

PIMCOs announcement above may be a nice contrarian indicator to get out of Treasurys for a little while … but then why would you want to daytrade such an investment … relax :)

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Gold Leaving the Leveraged Financial System …

… I love the fact that the mainstream media is beginning to make the connection between soaring gold prices, falling treasury yields, and deflation.

What comes to mind once again is the inverted pyramid of the global financial system:

… as actors in the global financial system deleverage their positions, funds tend to flow from the higher spheres (stocks, derivatives, etc.) to the lower ones (US government bonds, power money such as gold/silver).

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Gold Price Exceeds Platinum

For the first time in 2 1/2 years the gold price has exceeded that of platinum.

Back then the trend was reversed immediately.

According to Reuters this time gold is set to widen premium over platinum:

Gold prices rose above those of platinum for the first time since December 2008 late on Monday. The last time this happened, the situation reversed within a few days, and traders said then that the convergence of the gold-platinum ratio gave a clear signal to sell gold and buy platinum.

Today’s backdrop is very different.

“Gold as a defensive asset is being driven higher at the moment by risk aversion, and platinum as a cyclical asset is under pressure because growth is slowing,” said Michael Widmer, an analyst at Bank of America-Merrill Lynch.

“We were there around the great recession (2008), and then you had the various stimulus packages hitting the market, and you saw the prices of the two metals starting to diverge again,” he said. “The macro picture is a bit different this time around. I don’t think that it is a compelling trade.”

In contrast to the situation in 2008, gold’s premium to platinum is a function of its own strength, rather than a falling platinum price.

… interesting times.

Gold is a money commodity, platinum is not, at least it doesn’t seem to be acting like one.

In deflation money does well, all other commodities tank. I have said it many times before and over the past 3 years we have seen this theory confirmed beautifully.

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Treasuries May Crash, But Shorting Them Isn’t Worth the Risk

By: J. Tyler Matuella

Chasing the Next Treasure-y

Everyone has heard about the famed handful of investors—Michael Burry and John Paulson, amongst others—who saw the real estate bubble forming in the early 2000’s and purchased the lucrative credit default swaps to cash-in when the system collapsed. A couple of those investors made billions in a few months from essentially shorting mortgage-backed securities. Now it seems like there’s a new fad on the Street to discover the next bubble and short it, in hope of making record returns. Many of these hungry investors have turned their beady eyes to the U.S. Treasury market.

Record deficits, the European PIGS, and the Greek debt bailout have put sovereign solvency on the short list of investor concerns since the 2008-2009 financial crisis. Even as the world has seemingly recovered from the dark trenches of the crisis with the resurgence of the equity markets, many investors are still waiting for the real bang.

But they’re not just referring to the Eurozone debt turmoil across the pond. There has been a lot of talk recently about shorting U.S. Treasuries right here at home as sentiment about the unsustainability of the debt has reached a fever pitch.

Real Concerns, Real Consequences

The concerns are valid. Some people are worried that the U.S. government’s ballooning debt, coupled with a decreasing demand for Treasuries as the equity markets heat back up, will force the U.S. government’s borrowing rate to rise.

On a more pessimistic note, other investment analysts think that gridlock in the nation’s political system will prevent the government from passing tax hikes and spending cuts that are needed for the government to rein in the debt—the eventual implication is a Greek-like debt crisis. As Treasury Secretary Timothy Geithner warned in early January, “Even a short-term or limited default would have catastrophic economic consequences that would last for decades.”

Perhaps the best case scenario (for the United States, at least) for the fall of Treasury prices is that there’s a compelling argument for significant inflation in the near future. Massive amounts of increased government spending, tax cut extensions, and record low interest rates indicate that the economic system is flooded with cheap, pent-up money that will have to be spent at some point. When that happens, inflation will take charge and Treasury yields will have to jump to continue attracting investors. But at least the inflation will eat away the value of the U.S. national debt.

Small Upside, Large Downside

Short positions are already risky. Such is the case with any investment that has a finite upside and an unlimited downside—(although the downside of shorting Treasuries is not unlimited since most investors won’t accept large negative yields). Treasuries take the risk to a different level, however, and I will explain why it’s nearly impossible to earn a huge profit from simply shorting a bond or using a credit default swap on U.S. debt.

If bond prices fall, theoretically the return from shorting a U.S. Treasury could be anything from a few cents, to the entire value of the bond if the government defaults. To those who are convinced that Treasuries will tank because the insolvency threat is real and coming, then it doesn’t sound like a bad investment.

But there’s a key problem with that logic. Even though it may seem obvious, U.S. debt is denoted in dollars. That’s a critical distinction from Greek or Portuguese debt, which is denoted in a supranational currency—the Euro—rather that their own national currency. If investors are looking to earn landslide profits from a steep fall of Treasury prices because of rampant inflation or government default, then that very situation will correspondingly come with a huge decrease in the purchasing power of the U.S. dollar. Since U.S. debt is denoted in dollars, the purchasing power of that windfall profit from the Treasury short could drastically reduce the real return, depending on the severity of the price drop. There won’t be an opportunity to protect the profit by converting it to a foreign currency because the dollar value will simultaneously drop as the winnings are earned.

Some investors have bought credit default swaps on U.S. debt that pays in Euros. However, the exact same problem occurs in that situation as well. Large per-trade profit margins for retail investors are restricted because foreign banks will charge a premium, around the time of the crash in Treasury prices, to insure U.S. debt because they’re not only dealing with the chance of default, but also the foreign exchange risk. CDS are even more risky since they only pay out in the event of an actual default, and it’s very difficult to imagine that the U.S. government would choose to default instead of just running the printing presses more.

The chart below shows the nature of the restriction of real return per bond if an investor does a “simple” short on a 10-yr bond purchased at $100 face-value[1]:

Chart

Is It Still Worth It?

Now that we can see there’s inherently only a small to medium upside to shorting the U.S. Treasuries, the question remains, is that limited potential for gains still worth the risk?

The easy answer is that it depends on investors’ risk tolerance. If you’re a big risk taker or someone with lots of cash like a hedge fund, and if you can afford short term losses and don’t mind earning smaller margins per trade, then go for it. The potential for large absolute gains from making high-volume, small-margin trades still exists on a day-to-day basis without harm to the currency. Investors take advantage of small bond price movements every day. However, as I argued before, any large drop in bond prices will be self-defeating and inherently restricting. The “big bang” of profits that investors found in shorting the real estate market in 2008 simply doesn’t exist in the bond market, in part because of the different nature of the financial instruments used.

To more risk-averse investors, trying to profit by day-trading in the bond market may prove particularly difficult, given the current state of world affairs. If the events in Tunisia and Egypt have taught us anything in the past weeks, it’s that the prices of equities and Treasuries are not governed by purely market forces. Between January 25th and January 30th, investors exited equity positions and fled to the security of U.S. Treasuries amidst fears that turmoil in the Arab world could roil economic growth and pressure oil supplies.

Even with all of the convincing economic evidence for why bond prices should have been falling, bond prices rose for almost a full week while equities fell. Once investors realized their fears had no economic grounding, bond prices fell back and equities returned to normal. If someone shorted bonds that week, they would have lost a lot of money—the problem is that every economic model in the world couldn’t predict what happened in Egypt.

A Riskier Way to Short the Treasury Market

For small-cap retail investors who are certain that bond prices will fall in the coming months, there’s an alternative to take advantage of the fall in bond prices and still earn a huge return without the currency risk. Some inverse U.S. Treasury ETFs, such as the Horizons BetaPro U.S. 30-Year Bond Bear Plus ETF (HTD), allow investors to use leverage to short the U.S. bond market. This ETF is denominated in Canadian dollars, and it hedges against exposure to the U.S. dollar every day. As long as the investor considers the denominated currency’s home country to be “debt-stable,” then this investment avenue effectively reduces the currency risk.

However, there are some salient problems with investing in inverse ETFs—especially levered ones—from a risk-return standpoint. The returns on a daily basis of HTD, for example, range from +200% to -200% because of the leverage. As a result, holding onto these types of funds for more than a few days can be deadly. Treasury prices may fall for four straight days, earning the inverse ETF investors massive returns with leverage, but only one or two days of small to medium-sized losses later can negate multiple days’ gains, even to the point where the net return on investment is negative. While market fundamentals exhibit compelling evidence for why Treasuries should consistently fall, a little political turmoil around the world could cause Treasuries to rise again short-term and severely hamper the returns from inverse ETFs. Since investors really shouldn’t hold onto these levered inverse ETFs for more than a few days at a time because of the compounding high risk of doing so, investors will have to keenly get into them just before the debt crisis in order to earn massive returns—that is, if a U.S. debt crisis occurs at all.

If You Do It, Do It Right

Going short on bonds probably isn’t the best way to take advantage of a debt downgrade or rising inflation in the U.S. vis-à-vis going long on metals. But for investors who insist on taking the risk, the best way that I have heard to do so is to short the bond, take the money gained from the sale of the borrowed bond, and immediately put it in a forex Euro futures contract. That way, the investor locks in the exchange rate and preserves the purchasing power of the initial investment. Even if the dollar greatly depreciates in the meantime, the investor will still walk away with a solid gain. Depending on how far the bond price falls, the investor could still earn 60-70% per trade, though that size return is highly unlikely. In addition, the risk of betting against the world’s reserve currency over the course of an entire yearlong contract makes it an even riskier position, and perhaps more apparent why shorting Treasuries may not be worth the risk.

If You Play the Game, Know the Risks

The dollar still holds strong as the world’s reserve currency, which could prove an obstacle in the future to investors who short bonds amidst political turmoil in the Middle East. And since large profits (per trade) from shorting bonds are very unlikely even in the event of a debt crisis, it doesn’t make sense for most small-cap, retail investors to play the high risk, low return game that characterizes the bond market. However, for those who insist on profiting from shorting the potential debt crisis in the United States, doing a regular short and putting the initial payout in a forex Euro futures contract may be the best way to produce solid returns with minimal currency risk.


[1] Real return numbers are not exact at each bond price increment; may differ with different levels of inflation.

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Dollar, Gold, Treasurys Continue to Act Well

The Dollar

It’s important to cut out the noise you hear in the media from people who are incapable of looking at events past the duration of a week or so.

The dollar has been taking a break from its long term rally against the Euro, but continues to stay within the trading range that I have been eying for a while.

dollar-chart

It’s even possible that the Dollar falls further against the Euro to somewhere around 1.45, and then again rises to levels below 1.20.

Gold

Well, what should I say about gold. It continues to rise to record levels, hitting $1344 on Friday, while those who don’t understand the concepts of money and in particular gold during deflation angrily observe the trend with clueless stares.

gld-2

Treasury Yields

Treasury yields have hit a 20 month low and are now at 2.38 percent.

oct-2010

The alarm bells are ringing for equities … once more.

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