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The Hardest Trade to Make Today

By Amber Lee Mason, editor, DailyWealth Trader
Monday, May 12, 2014

I've never gotten more angry notes...
Back in August 2013, I recommended that readers of my DailyWealth Trader service buy shares of Bank of America (BAC). Long story short, banks were in a solid uptrend thanks to the Federal Reserve's huge "E-Z Credit" program.
Folks hated the idea of "getting into bed" with the government. Several threatened to cancel their subscriptions. I hope they stuck around... The trade ended up being a winner.
But even if they did stick around, they're likely done with me now...
You see, I recently recommended making a bullish bet on U.S. Treasurys...
To understand this trade, you need to know that Treasury prices have an inverse relationship with interest rates. In other words, Treasury prices rise as interest rates fall... And Treasury prices fall as interest rates rise. So when you make a bullish bet on U.S. Treasurys, you profit if interest rates go down.
Treasurys are basically loans to the U.S. government. And if you're a longtime reader of S&A content, you know the U.S. government is broke.
So why bet that the value of loans to the U.S. government is going to increase in value? Why bet that folks will accept a lower interest rate for making those loans?
Because nobody wants to make that bet.
Take a look at the chart below. It shows the number of existing shares of TBT... a "double-short" Treasury fund. (It gains 2% for every 1% drop in Treasury prices.) When people buy more shares of TBT, the fund creates more shares to meet demand.
The massive increase in existing shares shows you how many folks are now interested in betting against U.S. Treasurys.
TBT bond chart
Last month, at an investment conference held by well-respected newsletter writer Jim Grant, I heard a bit about what might cause some of those bets to reverse...
One of Grant's speakers was Marty Fridson... As my colleague and mentor Steve Sjuggerud detailed in a recent essay, Fridson is the "dean" of high-yield bonds. In his presentation, Fridson detailed why high-yield bonds – loans to riskier companies – are setting up for an implosion. (You can get the details in Steve's essay.)
And then Fridson detailed what else could happen as the "junk bond" market deteriorates...
You see, many bond funds have purchased higher-yielding bonds and sold short U.S. Treasurys. If junk-bond prices start to fall, these funds will have to "unwind" their trades... They'll sell junk bonds and buy Treasurys. As Fridson said, "It could lead to one of the greatest short-covering melt-ups in Treasury market history."
Below is a chart of TLT, which tracks the price of long-dated Treasurys (Treasurys that mature in 20-30 years). As I mentioned above, when interest rates rise, Treasury prices fall. So as interest rates have risen over the last two years, TLT has seen a huge drop. But it hammered out a bottom in the $100 area and has started to move higher.
TLT bond chart
This trend may not continue, of course. Interest rates are unpredictable. (There's an old joke about a recently deceased bond analyst: God asks him where he thinks interest rates are headed.)
But the trend is in favor of rising Treasury prices and lower interest rates. And there are a lot of people lined up on the other side of the bet.
If interest rates return to their levels of this time last year (about 2.87% for 30-year Treasurys), TLT will show investors a modest 10% gain. If they return to 2012 levels, TLT will rise about 20%.
You might hate the idea of making a bullish bet on the creditworthiness of the U.S. government. You're certainly not the only one... And it's likely the bears will win this argument in the long term.
In the shorter term (six months to several years), interest rates could drop lower and Treasury prices could rise.
It's a hard trade to make... But often, the hard trades are the right trades.
Good trading,
Amber Lee Mason

Further Reading:

"The Fed has demonstrated that it doesn't need to raise interest rates," Dr. David Eifrig writes. "Rates can stay as low as the Fed wants for as long as the Fed wants." Learn what you need to know about U.S. interest rates today here.
Steve Sjuggerud says for some countries, even negative interest rates are coming... "The idea of negative interest rates sounds insane," he writes. "You might think that no country in its right mind would move interest rates below zero... You would be wrong." So what should you do? Find out here

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