by Darwin on January 19, 2009

How to Short US Treasuries will likely become the idea du jour as the year progresses, especially if market conditions start to improve or if inflation returns to even average levels.  With new alternative investment instruments allowing for easy inclusion in this process of going short Treasury bonds, everyday investors will have access to this strategy as opposed to prior recessions.  The question is whether its too early now to cash in on this trend and whether the economic outlook is going to deteriorate further, which could send prices of US Treasury bonds even higher.

The case for Going Short Treasuries:

• The unprecedented move by the FOMC in December to cut the Fed Funds target rate to virtually 0% highlights the dire concerns about further deterioration of global economic conditions.  However, theres no more room to go.  With the Fed Funds target rate this low, there is no further opportunity to cut further, so Treasuries will not be impacted by any further cuts.
• Short term yields on Treasuries are close to zero.  In fact, Treasury note yields actually went negative during the back half of 2008.  While this seemed like a suitable option for investors in the midst of a complete market meltdown when they needed a guaranteed safe haven for near term liquidity requirements, this is likely not a prudent, sustainable investment option for money managers.  Looking out into the future, its likely that investors will tire of 0% or negative returns on their cash and their funds will find new avenues for low risk income.
• Our countrys insatiable appetite for debt, bailouts and trade deficits is obviously not bolstering the case for the US dollar.  While the dollar showed a brief rally during the economic collapse because we exported so much of our toxic waste assets to other countries, this again, was a one time event.  We will not be exporting toxic mortgage assets to Swiss banks, the Dubai investment authority and British banks 5 years from now.  However, we will still be reeling from the bailout bonanza, importing more than we export, and borrowing more than we makeits the American way!  This translates into a further weakening of the US dollar.  Wheres this all going? Foreign investors will be less likely to buy Treasuries moving forward, especially as global economic conditions improve, since they will perceive the future value of their investment as declining in terms of their own currencies.  If the US dollars going to drop, theyll be less inclined to buy Treasuries and the Short Treasury play will be viewed as prudent.

How to Short Treasuries:

There are a few ways to execute this strategy:

Update #1: There is now a 3X Short Treasury ETF — see full list of all 3X long/short ETFs and associated risks.

Update #2: Another way to play the US prospects and the weak US Dollar vs. other stronger economies is through various Currency ETFs (full list of all currency and leveraged currency ETFs)

Proshares Ultra Short 7-10Yr Treasury (PST ) — Twice the inverse of the daily performance of the Lehman Brothers 7-10 Year U.S. Treasury index.

Proshares Ultra Short 20 Yr Treasury (TBT ) Twice the inverse of the daily performance of the Lehman Brothers 20+ Year U.S. Treasury index.

Rydex Inverse Government Bond Strategy (RYJUX ) Inversely correlates to the price movements of the 30-year Treasury bond.

Risk/Benefit of Going Short US Treasuries

It appears as though theres a unique balance between low downside risk and high upside risk on this short treasury play since there isnt really much further for Treasuries to go being that the yields are teetering on a loss.  However, as conditions improve (which they ultimately will, its just a matter of when), and as Treasury bond prices return to parity, these investments will rise substantially.  Note that the ETFs cited are 2X inverse equivalents, so near term rallies in Treasuries could result in rapid drops in share prices.

What are your thoughts?  Time to Short or do Treasuries have more room to run?

Disclosure: Currently long TBT since the 3X Short Treasury ETF was not available yet at time of purchase.

Update: Have since closed TBT at $55 per share since I dont recommend holding leveraged ETFs long term.