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Shorting U.S. Treasuries, a Historic Sucker Bet

Shorting U.S. Treasuries, a Historic Sucker Bet

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Published by MKC Global
MKC Global Investments looks into the popular investment idea of shorting U.S. Treasuries. We look into why this may or may not be prudent and how assuming this trade too early may be the wrong investment.
MKC Global Investments looks into the popular investment idea of shorting U.S. Treasuries. We look into why this may or may not be prudent and how assuming this trade too early may be the wrong investment.

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Published by: MKC Global on Mar 12, 2010
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MKC G
LOBAL
I
 VESTMENTS, LLC Andrew McCormick March 11, 2010Managing Memberamccormick@mkcglobal.com+1 206.920.4788
 
Shorting U.S. Treasuries, a Historic Sucker Bet If forced into a career other than one in finance, researching investor psychology andgroupthink would be of great interest. The thought process for an individual during an investment is complex. The number of emotions combined with the financial stakes creates a decision-makingprocess worth studying.At times, investors can show a remarkable tendency towards herd mentality. This is clearlyevident in several historical markets and since then mainstream investors have tried to capitalizeon this behavior via the popular “contrarian” strategy in investing. Most people feel instinctivelydrawn to an established opinion, the consensus. People enjoy positive feedback and the feeling of being validated by the majority who share a similar opinion. This phenomenon has been welldocumented and can be seen throughout investment history: The South Sea Bubble, Tulip BulbMania, railroad stocks, gold in 1979, the Tech Bubble, residential real estate, etc. These are primeexamples of investment groupthink. To a lesser extent, this same mentality occurs outside periodsof incredible asset appreciation as well and it is particularly evident right now in regard to thepublic’s perception of the United States Treasury market.The immensely popular investment idea, namely to short U.S. Treasuries, may be the largest sucker bet in many, many years. Instead, buying longer duration government bonds (U.S, Europeanor Japanese) before the final stage of an epic 30 year bull market could prove to be one of thesmartest trades of the last decade. Although buying Treasuries may or may not be the best trade interms of sheer magnitude of price movement, it will prove to be the essence of investing; findinggenuine value in a loathed asset and knowing when to part company with the crowd. Buying SpringWheat in 2005 or shorting crude oil in the summer of 2008 may prove more financially rewarding,but buying government bonds will be more satisfying since very few believe in a potential advance.In 2009, the debate between inflation and deflation was fierce. Now it seems the generalpublic agrees that inflation hides around the corner due to massive money printing. Marc Faberenjoyed comparing the United States to Zimbabwe and stated that “Ben Bernanke appears to haveRobert Mugabe as his mentor”. So far, we have seen little evidence of any inflation; instead on thecontrary, prices have been falling. According to Bloomberg the financial crisis eradicated almost $14.5 trillion dollars in wealth compared to the almost $3 trillion spent in bailout and stimulusprograms. Three trillion has not been nearly enough to cause hyper-inflation in this environment compared to the contraction in credit and wealth. The monetary base has exploded, but so hasreserve bank credit. The money isn’t getting out to the economy, and the velocity of money (animportant component to inflation) continues to shrink.David Rosenberg, Chief Economist and Strategist of Gluskin Sheff recently presented someinteresting data in regard to the average U.S. household balance sheet. The data shows that U.S.households own $800 billion in Treasury notes compared to $3.5 trillion in corporate bonds andmunicipal paper, $4.6 trillion of consumer goods, $7.7 trillion of deposits and cash, $18.1 trillion of equities (after the bear market) and $18.2 trillion in residential real estate (after three years of dropping values). A quick back-of-the-envelope calculation from that data shows that Treasuriesmake up less than 2.7% of total household liquid (excluding consumer goods and residential real
 
MKC G
LOBAL
I
 VESTMENTS, LLCMarch 11, 2010
 _____________________________________________________________________________________
info@mkcglobal.com www.mkcglobal.com 206.920.4788
estate) assets and less than 1% of total assets. Treasuries are clearly under-owned, especially in theface of another downturn in equities when investors will demand safe assets.For many years now, traders and portfolio managers have been salivating at the idea of shorting Japanese Government Bonds, citing the country’s high debt to GDP ratios and history of quantitative easing. Japan is the real world proof that U.S. and European government bonds cancontinue to move significantly higher and yields can move much lower than anyone thought possible, even in the face of what seems like unsustainable government debt. JGBs rose to a high in2003 and that high is about to be challenged again. That high in bond prices saw a correspondinglow in yields of 1.049%. If the yield on U.S. 10 year notes drops to the same level the bond pricewould rise to approximately $146.00, a 24% rally from current levels.Some trades are good enough to assume just from a contrarian standpoint. The basics of acontrarian “play” is that when everyone moves to one side of the trade, there are so few new buyers(or sellers) to get on board and maintain the price movement that prices will swing the other way.The case for a contrarian trade in government bonds is perfectly clear. CNBC and Bloombergroutinely have guests and analysts making their all too common case for shorting government bonds. The financial gurus (some of which I respect very much) like Jim Rogers, Marc Faber, PeterSchiff and Nasim Taleb all preach the same trade. In fact, Mr. Taleb recently stated that “everyhuman should short U.S. Treasuries”, a statement he will most likely regret for some time. Financialmagazines such as Smart Money and Forbes have published feature articles about the Treasury“bubble” and impending high interest rates. Many financial bloggers and small speculators love thistrade as well, typically citing the previous sources for their research. Even Pro Shares launched twoUltra-Short Treasury ETFs in early 2008, which would rise in value if U.S. Treasuries declined. It seems that all components of a contrarian trade exist. At some point all these market participantswill be absolutely correct, government bonds will decline dramatically and interest rates will rise.They are not wrong, just too early.

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