Tags: Shorting | Treasurys | Bad | Move

The Long and Short of Betting on a Bond Bubble

By    |   Thursday, 22 March 2012 01:44 PM

Wilbur Ross, president of W.H. Ross & Co., was on CNBC this week, discussing various topics.

Ross is a famous value investor, who likes investing in ailing companies, with the hope of fixing them up. Ross is extremely bullish on natural gas and has been investing his money in specific companies in that area.

There was one part of the interview where Ross made a very strong statement. Ross stated: "I rather be in equities than in 10-year Treasurys. The greatest bubble that's about to burst is the 10-year and longer Treasurys because the idea that inflation is gone forever and for all time — and therefore these artificially low rates can last — is silly."

Other famous investors have been issuing the same warnings. Seth Klarman has been shorting Treasurys since at least 2010. Klarman has more recently bought deep out of the money puts, which would profit if rates rise significantly. He thinks that the Federal Reserve might have to raise interest rates into double-digit territory to combat inflation.

Listening to this advice could be dangerous for two reasons.

Investors who want to short Treasurys could short ETFs such as TLT or TBT. (TLT is the ishares 20-year Treasury index.)

These instruments, for complicated reasons, don't do exactly what they are supposed to do. For example, if the 20-year Treasury bond goes down 20 percent, TLT might go down 5 percent or even go up. These instruments are usually designed to make money for the issuing firms, but not for the retail investor.

There are simply no instruments for retail investors to properly short U.S. government Treasurys.

The second reason is even more important. Unlike other bubbles, where the Federal Reserve could do certain things to prevent them, Treasurys work in an entirely different way.

The Federal Reserve controls U.S. interest rates. The Federal Reserve has another power most people don't realize. The Federal Reserve, in effect, not only controls interest rates, but can and does manipulate Treasury bond yields.

The Federal Reserve can start buying Treasurys in order to lower the yields whenever it wants.

Of course, this could have other undesirable effects. However, it seems many great investors lose sight of this fact.

As an example of a bad trade, investors can look at Japan. The country has had ultra-low interest rates for 20 years. Many great investors have shorted Japanese Government Bonds in hopes of turning a profit off rising rates.

None of them have succeeded, and it has been one of the worst investments of the past 20 years.

The reason is that Japan, like America, has a central bank which can buy Treasurys and also has a Treasury which issues bonds in their own currency.

Everyone should be concerned about the national debt, but to compare America to Greece is faulty logic.

For the above two reasons cited, investors must be cautious before shorting U.S. Treasury bonds.

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Thursday, 22 March 2012 01:44 PM
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