Don't fight the Fed, yet

There has been lots of chatter about the recent drop in the 30 year bond price. The debate is focused on “Is the Fed still in charge of monetary policy?” or “Is there really an deflationary scenario unfolding that justifies this currency debasing through debt?” For investors looking for low risk gains, this great theoretical debate provides ample opportunity to make a profit.

There are lots of solid alarmist reasoning from a theoretical point of view like the overall amount of debt, the increased frequency of Treasury auctions, etc. If we were debating in my college Econ 101 class, the idea of massive stimulous financed by lots of long term debt with the current outstanding account deficit would be considered an instant receipe for disaster in a perfect system. Sure, there is an increasing risk that we will hit a magical limit of borrowing and foreigners will flee and put their money under their mattress. But this is reality and the world does not operate according to models.

First of all, in the world of investment choices for sovereign nations, there are really very limited choices regarding where to put major currency. The Japanese economy is currently declining at a 13% annualize rate and heavily dependent on exports to suffering economies. The European banking system is still unraveling and considered to be insolvent. With this in mind, and a limited amount of canned beans, shotgun ammo, and gold bullion available to buy, the Treasury bond market will still see a thriving business.

The Chicken Littles love to tell stories about how the Chinese, Europeans, and Oil Barons are crazy for buying 30 Year Treasury Bonds at 3.5% and will soon take their money home for domestic investment for higher returns. This logic is flawed for two reasons. 1) A purchase of Treasuries increases in return if a government believes that it’s home currency could possibly devalue versus the USD due to global deflation. In such case, the USD denominated Treasuries provide a highest quality hedge for against any internal stability risk and also against lagging relative performance versus the US economy. 2) The second reason is because of the Federal Reserve's power as a market maker. Besides the Fed Discount rates, the Fed also has the ability to control rates buy choosing where on the yield curve it issues debt, or “paint the tape” as it is called.

From Across the Curve, Feb 4th, 2009 “The Treasury did announce that they will auction $32 billion 3 year notes, $21 billion 10 year notes and $14 billion Long Bonds next week. That package is in line with street estimates.

What was not in line was the profile of the new 7 year note which will be auctioned at the end of this month. Most street analysts had anticipated that there would be a 7 year note and it would be issued quarterly. The Treasury opted for a monthly 7 year note. The private sector Treasury Borrowing Advisory Committee has recommended that the new note should be auctioned for $15 billion at its initial offering at the end of the month.”

So although the amount of debt overall and amount debt sold over the next few years may increase greatly, the notes sold at the shorter maturities will probably be the bulk of the issue, not the 30 year. Thus the Fed will be able to use the proportionately small amount of 30 year Treasuries to request higher bids for the debt.

This is a significant event, and a prudent market move by the Treasury. It is easy to see a sizable profit margin in selling 3-yr, 5-yr, or 7 yr debt when one views the medium term view to present scenarios of zero to even high single digit deflation. For the Chinese, buying up these medium term instruments provides a high degree of safety and a high yield for a negative interest rate environment.

As much as you may not like it, or if it breaks all of the old rules of investing that you have learned, in short term, the Treasury will be able to issue more debt to fund even larger government economic initiatives. Yet we cannot increase or deficits too much or we face a situation where we will debase our currency.

What is an investor to do to profit from this situation?

There are only really two acceptable outcomes on which to base trading positions: 1) The Fed is on the brink and foreigners will flee in the immediate future 2) The Fed still has fighting power, even solid demand, and will have a linearly increasing chance of a day of reckoning in the unforeseeable future (foreseeable meaning a year or less in this chaotic environment).

In the case you are in the #2 camp, then like me, you need to go long TLT. Even with the new stimulus package and the plethora of financial stability programs du jour, the government will only have spent 40% of GDP. This is a comfortable deficit number considering the situation, according to economists like Paul Krugman and Mark Zandi. Thus in the short term the Fed will make purchases and bring the 30 year down to make house prices affordable using 30 year fixed instruments. With all of this uncertainty long term, that is all you need to know. Sure, there will be TARP 2.0, 3.0 and probably 4.0. But this is speculation for the next Federal budget cycle, and can only be addressed through futures or long term options. In the meantime, benefit from the Fed effort to manipulate the long term rates and let the future worry about itself.

Thus the author expects the Fed to bring Treasury 30 year rates down to 2.5% to enable the mortgage market to provide financing at a desired 4.5% 30 year fixed rate.

The author is short TLT $94 JUN 09 puts at $3.3 and long TLT $91 JUN 09 puts at $2.25.

The author is also long TLT $105 SEPT 09 calls at $5.5.

(Each investment will be treated as 50% of the total position)