Treasuries May Crash But Shorting Them Isn’t Worth the Risk

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Treasuries May Crash, But Shorting Them Isn't Worth the Risk By: J. Tyler Matuella Chasing the Next Treasure-y Everyone has heard about the famed handful of investors—Michael Burry and John Paulson, amongst others—who saw the real estate bubble forming in the early 2000's and purchased the lucrative credit default swaps to cash-in when the system collapsed. A couple of those investors made billions in a few months from essentially shorting mortgage-backed securities. Now it seems like there's a new fad on the Street to discover the next bubble and short it, in hope of making record returns. Many of these hungry investors have turned their beady eyes to the U.S. Treasury market. Record deficits, the European PIGS, and the Greek debt bailout have put sovereign solvency on the short list of investor concerns since the 2008-2009 financial crisis. Even as the world has seemingly recovered from the dark trenches of the crisis with the resurgence of the equity markets, many investors are still waiting for the real bang. But they're not just referring to the Eurozone debt turmoil across the pond. There has been a lot of talk recently about shorting U.S. Treasuries right here at home as sentiment about the unsustainability of the debt has reached a fever pitch. Real Concerns, Real Consequences The concerns are valid. Some people are worried that the U.S. government’s ballooning debt, coupled with a decreasing demand for Treasuries as the equity markets heat back up, will force foreign creditors to raise the U.S. government's borrowing rate. On a more pessimistic note, other investment analysts think that gridlock in the nation's political system will prevent the government from passing tax hikes and spending cuts that are needed for the government to rein in the debt—the eventual implication is a Greek-like debt crisis. As Treasury Secretary Timothy Geithner warned in early January, “Even a short-term or limited default would have catastrophic economic consequences that would last for decades.” Perhaps the best case scenario (for the United States, at least) for the fall of Treasury prices is that there's a compelling argument for significant inflation in the near future. Massive amounts of increased government spending, tax cut extensions, and record low interest rates indicate that the economic system is flooded with cheap, pent-up money that will have to be spent at some point. When that happens, inflation will take charge and Treasury yields will have to jump to continue attracting investors. But at least the inflation will eat away the value of the U.S. national debt. Small Upside, Large Downside Short positions are already risky. Such is the case with any investment that has a finite upside and an unlimited downside. Treasuries take the risk to a new level, however, and I will explain why it's nearly impossible to earn a huge profit from shorting a bond. If bond prices fall, theoretically the return from shorting a U.S. Treasury could be anything from a few cents, to the entire value of the bond if the government defaults. To those who are convinced that Treasuries will tank because the insolvency threat is real and coming, then it doesn't sound like a bad investment. But there's a key problem with that logic. Even though it may seem obvious, U.S. debt is denoted in dollars . That's a critical distinction from Greek or Portuguese debt, which is denoted in a supranational currency—the Euro—rather that their own national currency. If investors are looking to earn landslide profits from a steep fall of Treasury prices because of rampant inflation or government default, then that very situation will correspondingly come with a huge decrease in the purchasing power of the U.S. dollar. Since U.S. debt is denoted in dollars, the purchasing power of that windfall profit from the Treasury short will drastically reduce the real return or even effectively wipe it out, depending on the severity of the price drop. There won't be an opportunity to protect the profit by converting it to a foreign currency because the dollar value will simultaneously drop as the winnings are earned. Some investors have tried to hedge that risk by buying credit default swaps on U.S. debt that pays in Euros. However, the exact same problem occurs in that situation as well. Large per-trade profit margins for retail investors are restricted because foreign banks will charge a hefty premium to insure U.S. debt because they're not only dealing with the chance of default, but also the foreign exchange risk. Therefore, it looks like there's even smaller profit potential from shorting a bond versus shorting a normal security or commodity. The profit potential—because of the corresponding erosion of the dollar, the fact that the debt is in dollars, or because of the forex risk premium—is greatly limited and may not be worth the risk. The chart below shows the nature of the restriction of profit (return) as the price of a 10-yr bond purchased at $100 face-value decreases (Real return numbers are not exact at each bond price increment.): Is It Still Worth It? Now that we can see there's inherently only a small to medium upside to shorting the U.S. Treasuries, the question remains, is that limited potential for gains still worth the risk? The easy answer is that it depends on investors’ risk tolerance. If you're a big risk taker or someone with lots of cash like a hedge fund, and if you can afford short term losses and don't mind earning smaller margins per trade, then go for it. The potential for large absolute gains from making high-volume, small-margin trades still exists on a day-to-day basis without harm to the currency. Investors take advantage of small bond price movements every day. However, as I argued before, any large drop in bond prices will be self-defeating and inherently restricting. The “big bang” of profits that investors found in shorting the real estate market in 2008 simply doesn't exist in the bond market. However, to more risk-averse investors, trying to profit by day-trading in the bond market may prove particularly difficult, given the current state of world affairs. If the events in Tunisia and Egypt have taught us anything in the past weeks, it's that the prices of equities and Treasuries are not governed by purely market forces. Between January 25th and January 30th, investors exited equity positions and fled to the security of U.S. Treasuries amidst fears that turmoil in the Arab world could roil economic growth and pressure oil supplies. Even with all of the convincing economic evidence for why bond prices should have been falling, bond prices rose for almost a full week while equities fell. Once investors realized their fears had no economic grounding, bond prices fell back and equities returned to normal. If someone shorted bonds that week, they would have lost a lot of money—the problem is that every economic model in the world couldn't predict what happened in Egypt. If You Play the Game, Know the Risks The dollar still holds strong as the world's reserve currency, which could prove an obstacle in the future to investors who short bonds amidst political turmoil in the Middle East. And since large profits (per trade) from shorting bonds are inherently impossible, it doesn't make sense for most investors—especially retail investors—to play the high risk, low return game that characterizes the bond market. J. Tyler Matuella is a guest writer for Stockerblog.com

Treasuries May Crash But Shorting Them Isn't Worth the Risk