The ProShares UltraShort 20+ Year Treasury ETF (Public, NYSE:TBT) is an interesting prospect for those that expect higher inflation and higher interest rates. TBT is an ETF that is held by 5 gurus tracked by Gurufocus. This article argues that higher interest rates are coming and that in turn higher interest rates will occur. With higher interest rates, the yield of long term treasuries will increase and in turn, the markets values of these treasuries will drop. This will cause the market value of this ETF to increase.
TBT is currently held by 4 gurus tracked by Gurufocus and discussed below. It is an Exchange Traded Fund that shorts US Treasuries with maturities greater than 20 years. TBT does the exact opposite of what the iShares Lehman 20+ Year Treasury ETF (Public, NYSE:TLT) does. To see the inverse correlation of TBT and TLT, consider the chart that can be found at Google finance.
The ProShares UltraShort 20+ Year Treasury seeks daily investment results, before fees and expenses and interest income earned on cash and financial instruments, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Index. - source
The argument for inflation
Why is this a good idea for value investors? To begin, it is assumed that everyone has read the Warren Buffett op-ed piece called "The Greenback Effect". If you have not read this yet, please do so now. It is short and to the point. In it, Buffett hints that higher inflation is likely. He wrote that "Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes."
I am in the camp that inflation is coming. High levels of debt are not the issue. It's the public debt relative to Gross Domestic Product(GDP) that is the issue that puts the economy at risk. It's this ratio that is out of whack. GDP was last reported on February 26, 2010 as being $14.5 trillion. Total public debt (not including Intragovernmental Holdings) is about $8.0 trillion. The public debt to GDP ratio is currently 55%. During The Great Depression, this ratio went up to the 110-120% range. Post Great Depression, this number has been much lower, in the 25-45% range. It is desirable to keep this ratio well under 50%.
While a public debt to GDP ratio of 55% is not horrible (about 20% over the high end of historical norms), there is a likelihood that inflation will be used as a tool to fix it.
How will inflation fix things? Quite simply actually. Gross debt already exists. Inflation does not effect debt one already has. But what about GDP? If inflation were to occur, GDP will ultimately go up with it. The printing of more dollar bills simply means more will be paid for the same goods and services. GDP represents the market value of all goods and services made within the US over the course of one year. As GDP goes up, the gross debt to GDP ratio will drop.
So, how much inflation? If there is 25% inflation, GDP will go up from $14.5 trillion to $18.1 trillion. Assuming public debt is still $8.0 trillion, that would put the ratio at a more reasonable 44%. Of course, public debt will change over time. If public debt increases, inflation will have to be even higher than 25% to get this ratio back to the same 44%.
If public debt increased 10% in the above example, public debt would be $8.8 trillion. Making the public debt to GDP ratio 48.6%.
There is a fix coming to the issues with public debt. It's name is inflation. And it will probably be well over 25% over the course of several years. The level and duration of inflation are unknowns but the long term impact is a certainty. It could be 1 year at 30% or 3 years at 10%.
What's all this talk about inflation for?
Inflation is the catalyst that may very well bring interest rates up. There are a handful of things that influence interest rates. Among them are the economy, inflation, prime rate movements and even the stock market.
Focusing on inflation and the prime rate, consider the following. If inflation occurs, the Federal Reserve will undoubtedly make changes to the Federal Funds Rate and the Federal Discount Rate in order to minimize the amount of inflation. These two rates, in turn, impact the prime rate at which lending institutions lend money. As the prime rates go up so will interest rates since they are tied to the prime rate.
For this and other reasons, interest rates will go up on various investment vehicles such as savings accounts and CDs. As these yields go up, so will the yield on treasuries since they are in competition with one another.
What does this all have to do with long term US Treasuries?
20 and 30 year US Treasury yields are currently floating at around 4.5%. It is not out of the question to see these yields rise to over 8% if inflation takes hold. While such yields sound high, remember that in the 1980s, yields were almost always over 8%. Also, today's yields are at the lowest levels they have seen since 1977 (based on federalreserve.gov data that goes back to 1977). Some reading this will remember the investment opportunities available at banks in the early 1980s that offered double digit yields.
To understand why shorting long term treasuries is the way to go, consider two extremes. A 3 year treasury and a 30 year treasury. For simplification let us say that they are both at 100% of par value (par value is the value of the treasury at maturity) and have 4% yields. At the same time assume that CDs yield 4%. These are not actual numbers, just simple numbers that are being used to illustrate a point.
If Interest rates go up, so will the yield on CDs. Assume that CD yields go up to 8%. Since treasuries will be worth 100% of par value at maturity, the 3 years treasuries might drop to 80% of par value and have a 5% yield. This is because they will mature in less than 3 years, giving the investor 100% of par value back. But very long term treasuries could drop in market value significantly more. In this example, assume that they could drop to 50% of par value in order to yield 8%. It will take up to 30 years for that market value of 50% of par to reach 100% of par which is only a doubling of the capital investment. With such a long time horizon, a yield close to 8% may actually occur. Such yields will not occur treasuries that mature in only a few years.
The point of this is that long term treasuries are impacted much more than short term treasuries when interest rates go up since the maturity dates are out further. This is how shorting long term and not short term treasuries can be profitable in a high interest rate environment.
And the Gurus that see higher interest rates?
PROSHARES TRUST is owned by 4 Gurus
3 Gurus Initiated Positions in TBT: George Soros initiated a position in the quarter that ended on 12/31/2009. John Keeley initiated a position in the quarter that ended on 12/31/2009. Jean-Marie Eveillard initiated a position in the quarter that ended on 12/31/2009.
1 Guru Kept Positions in TBT Unchanged or Slightly Adjusted: Richard Snow was a holder as of 12/31/2009.
Conclusion:
Because of the current public debt to GDP ratio, GDP will need to be artificially increased through inflation. By doing this, GDP will be impacted directly. Due to forces such as the impact of inflation on lending institutions and prime rate concerns, interest rates are bound to go up which will impact the yields expected by investors of low risk investment vehicles such as CDs. This expectation of higher yields will push long term treasury prices down on the free market in order for investors to attain higher yields on them. Which makes the idea of shorting long term US Treasuries attractive. Therefore, consider going long the ProShares UltraShort 20+ Year Treasury ETF (Public, NYSE:TBT).
DISLOSURE: The author of this article does not currently hold any ETFs mentioned even though he is currently considering TBT.
LINKS:
public debt information
GDP data
US Treasury yields
TBT is currently held by 4 gurus tracked by Gurufocus and discussed below. It is an Exchange Traded Fund that shorts US Treasuries with maturities greater than 20 years. TBT does the exact opposite of what the iShares Lehman 20+ Year Treasury ETF (Public, NYSE:TLT) does. To see the inverse correlation of TBT and TLT, consider the chart that can be found at Google finance.
The ProShares UltraShort 20+ Year Treasury seeks daily investment results, before fees and expenses and interest income earned on cash and financial instruments, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Index. - source
The argument for inflation
Why is this a good idea for value investors? To begin, it is assumed that everyone has read the Warren Buffett op-ed piece called "The Greenback Effect". If you have not read this yet, please do so now. It is short and to the point. In it, Buffett hints that higher inflation is likely. He wrote that "Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes."
I am in the camp that inflation is coming. High levels of debt are not the issue. It's the public debt relative to Gross Domestic Product(GDP) that is the issue that puts the economy at risk. It's this ratio that is out of whack. GDP was last reported on February 26, 2010 as being $14.5 trillion. Total public debt (not including Intragovernmental Holdings) is about $8.0 trillion. The public debt to GDP ratio is currently 55%. During The Great Depression, this ratio went up to the 110-120% range. Post Great Depression, this number has been much lower, in the 25-45% range. It is desirable to keep this ratio well under 50%.
While a public debt to GDP ratio of 55% is not horrible (about 20% over the high end of historical norms), there is a likelihood that inflation will be used as a tool to fix it.
How will inflation fix things? Quite simply actually. Gross debt already exists. Inflation does not effect debt one already has. But what about GDP? If inflation were to occur, GDP will ultimately go up with it. The printing of more dollar bills simply means more will be paid for the same goods and services. GDP represents the market value of all goods and services made within the US over the course of one year. As GDP goes up, the gross debt to GDP ratio will drop.
So, how much inflation? If there is 25% inflation, GDP will go up from $14.5 trillion to $18.1 trillion. Assuming public debt is still $8.0 trillion, that would put the ratio at a more reasonable 44%. Of course, public debt will change over time. If public debt increases, inflation will have to be even higher than 25% to get this ratio back to the same 44%.
If public debt increased 10% in the above example, public debt would be $8.8 trillion. Making the public debt to GDP ratio 48.6%.
There is a fix coming to the issues with public debt. It's name is inflation. And it will probably be well over 25% over the course of several years. The level and duration of inflation are unknowns but the long term impact is a certainty. It could be 1 year at 30% or 3 years at 10%.
What's all this talk about inflation for?
Inflation is the catalyst that may very well bring interest rates up. There are a handful of things that influence interest rates. Among them are the economy, inflation, prime rate movements and even the stock market.
Focusing on inflation and the prime rate, consider the following. If inflation occurs, the Federal Reserve will undoubtedly make changes to the Federal Funds Rate and the Federal Discount Rate in order to minimize the amount of inflation. These two rates, in turn, impact the prime rate at which lending institutions lend money. As the prime rates go up so will interest rates since they are tied to the prime rate.
For this and other reasons, interest rates will go up on various investment vehicles such as savings accounts and CDs. As these yields go up, so will the yield on treasuries since they are in competition with one another.
What does this all have to do with long term US Treasuries?
20 and 30 year US Treasury yields are currently floating at around 4.5%. It is not out of the question to see these yields rise to over 8% if inflation takes hold. While such yields sound high, remember that in the 1980s, yields were almost always over 8%. Also, today's yields are at the lowest levels they have seen since 1977 (based on federalreserve.gov data that goes back to 1977). Some reading this will remember the investment opportunities available at banks in the early 1980s that offered double digit yields.
To understand why shorting long term treasuries is the way to go, consider two extremes. A 3 year treasury and a 30 year treasury. For simplification let us say that they are both at 100% of par value (par value is the value of the treasury at maturity) and have 4% yields. At the same time assume that CDs yield 4%. These are not actual numbers, just simple numbers that are being used to illustrate a point.
If Interest rates go up, so will the yield on CDs. Assume that CD yields go up to 8%. Since treasuries will be worth 100% of par value at maturity, the 3 years treasuries might drop to 80% of par value and have a 5% yield. This is because they will mature in less than 3 years, giving the investor 100% of par value back. But very long term treasuries could drop in market value significantly more. In this example, assume that they could drop to 50% of par value in order to yield 8%. It will take up to 30 years for that market value of 50% of par to reach 100% of par which is only a doubling of the capital investment. With such a long time horizon, a yield close to 8% may actually occur. Such yields will not occur treasuries that mature in only a few years.
The point of this is that long term treasuries are impacted much more than short term treasuries when interest rates go up since the maturity dates are out further. This is how shorting long term and not short term treasuries can be profitable in a high interest rate environment.
And the Gurus that see higher interest rates?
PROSHARES TRUST is owned by 4 Gurus
3 Gurus Initiated Positions in TBT: George Soros initiated a position in the quarter that ended on 12/31/2009. John Keeley initiated a position in the quarter that ended on 12/31/2009. Jean-Marie Eveillard initiated a position in the quarter that ended on 12/31/2009.
1 Guru Kept Positions in TBT Unchanged or Slightly Adjusted: Richard Snow was a holder as of 12/31/2009.
Conclusion:
Because of the current public debt to GDP ratio, GDP will need to be artificially increased through inflation. By doing this, GDP will be impacted directly. Due to forces such as the impact of inflation on lending institutions and prime rate concerns, interest rates are bound to go up which will impact the yields expected by investors of low risk investment vehicles such as CDs. This expectation of higher yields will push long term treasury prices down on the free market in order for investors to attain higher yields on them. Which makes the idea of shorting long term US Treasuries attractive. Therefore, consider going long the ProShares UltraShort 20+ Year Treasury ETF (Public, NYSE:TBT).
DISLOSURE: The author of this article does not currently hold any ETFs mentioned even though he is currently considering TBT.
LINKS:
public debt information
GDP data
US Treasury yields
