Sunday, July 25, 2010

Understanding The Trade of the Generation On Multiple Levels

It's been a long time since I posted, much less written about something interesting. In all the passing moments of the last few weeks the trade of the generation (i.e. short long term treasuries / long precious metals) has been at the front of my mind. There are many ways to express this trade - so many in fact, that it merits future posts. There is also plenty of time to make those trades, so I think today is better focused on the "why" and the "how." In other words - WHY does the trade of the generation even exist?

Let's talk about the long leg first - PRECIOUS METALS. Why are precious metals in a bull market for the last 10 years and why might that bull leg go parabolic over the next 5 years? Let's just talk supply and demand. And lets talk about money. There is a major demand for SOUND money during the last three years of financial crisis around the world. None of the major fiat currencies (re: euro, swiss franc, dollar, or yen) appear to fit the bill of sound money. Why? They are being used by the various countries for political ends and policy goals INSTEAD of protecting the savings of the creditors (re: wealthier people or older people who actually saved something in life). Instead the POLITICIANS want to favor the debtors and work off the giant debt overhang in the western financial system. This requires PRINTING a ton of fiat currency. Instead of fiat, where people are looking for SOUND money, the only investment of interest which presents itself are the precious metals which have historically and probably during the immediate future will act as the only sound money. That is where the demand is coming from for precious metals. What about the supply? There just isn't that much yet. Especially if you consider the possibility of investment managers beginning to include precious metals as 5-10% of asset allocation recommendation which is certainly feasible and has a historical and sound fundamental basis. I don't really find the long leg that interesting other than to say that it is fundamental to the trade of generation.


What is more interesting conceptually? The short leg of course - SHORT long term TREASURIES or sovereign bonds of your debtor nation of choice (re: Greece, Spain, Japan, etc.). I will try to bring everyone up to speed on the fundamentals first. We are talking long term bonds here. Long term bonds have a price which we will call 100, 1000, 1M - basically the PAR VALUE. This par brings with it an interest rate depending on when the bond was sold. Bonds issued during the past 10 years have interest rates varying between 1% and 6% depending on the country of sale and the year of sale. Right now US long term treasuries are around the 3% level.


When interest rates fall (i.e. YIELD of the bond) so that long term treasury yields 2% in the market instead of 3%, the bond purchased at 100 and 3% yields increases in PRICE. It is relatively simple to do the calculation once you get the concept. I buy 10 year treasury bond yielding $3,000 per $100,000 (3%). Market interest drops to 2% - i.e. new investor has to pay $100,000 for $2,000 per year of interest. They will be willing to pay MORE for my bond. How much more? $50,000 more or $150,000. Actually this is NOT TRUE, because the bond is for 10 years instead of infinity. Because of the 10 year duration - the price increase may only be $10,000 but the CONCEPT is the same and I think it has been adequately explained here.


So the light bulb should be going on now in everyone's head - mainly - how do I short the bond and more importantly WHEN. We will talk about the how in future posts but the WHEN is really the difficult if not impossible question. One of my personal heroes - Jim Rogers, along with another - Marc Faber - have been discussing this important question in public for years - notably back when treasuries were yielding 4 or even 5%. Now they are yielding 3%. What does this mean? Even for the best INVESTORS - timing is difficult. My personal projections identify an important short point around 1.5% on the 10 year yield. I come up with this based on three important players 1) the economy, 2) the US treasury and 3) the Federal Reserve.

The economy is weak and doesn't appear to be improving much at all over past few years. Weak economic growth has traditionally meant low inflation and low interest rates. So far this has also been the case during America's great recession of 2008 and for those in the reality based community America's Great Depression - #2.

What about the US Treasury? The US treasury sells US government bonds in order to raise dollars for Congress to spend into the economy. This is called "fiscal stimulus" and was recommended at length by Sir John Maynard Keynes. This administration, Congress, and Treasury is no slouch. They are selling 2 trillion of bonds annually with projections all over the map for the next 2 years. Who are their buyers? Foreign countries and investors, major US Banks (who get free money from the FED), and institutional investors. There are not enough REAL buyers in the above discussion to soak up 2 trillion per year of issuance. All else equal, we should be seeing higher US treasury rates. The Government has an ace up their sleeve however which is the Federal Reserve.

How does the Federal Reserve play into this? They can create money out of thin air (without limit) and lend it out to major banks at 0% interest. The banks can then take this money and relend it to debtors. The typical targets of loans are US consumers and businesses. The target of the loans over the past two years has been not suprisingly the US government. Within one intermediated step between the Fed and the treasury (US money center banks) the Fed is able to "lend" (and I use that termly loosely) hunders of billions if not trillions annually to the Treasury which keeps long term treasury rates ARTIFICIALLY low around 3% and lower because of the fake demand from the Fed.

Where can this take us? Based on the needs of the US government to borrow and the weakness of the economy I think we can go to sub 2% yields on the 10 year - probably somewhere around 1.5%. At that point I believe the short position can be commenced through dollar cost averaging - with a target accumulation period of 12 months. Even if your average short yield winds up around 2.5% - you will have done well by controlling your risk. Always remember that picking a bottom is not easy and you have a 30 year TREND of falling interest rates working against you:






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