8/14/2019 Shorting U.S. Treasuries, a Historic Sucker Bet

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MKC GLOBAL IVESTMENTS, LLC

Andrew McCormick MarcManaging Memberamccormick@mkcglobal.com+1 206.920.4788

Shorting U.S. Treasuries, a Historic Sucker Bet

If forced into a career other than one in finance, researching investor psychology andgroupthink would be of great interest. The thought process for an individual during an investmentis complex. The number of emotions combined with the financial stakes creates a decision-makingprocess worth studying.

At times, investors can show a remarkable tendency towards herd mentality. This is clearlyevident in several historical markets and since then mainstream investors have tried to capitalizeon this behavior via the popular contrarian strategy in investing. Most people feel instinctivelydrawn to an established opinion, the consensus. People enjoy positive feedback and the feeling ofbeing validated by the majority who share a similar opinion. This phenomenon has been welldocumented and can be seen throughout investment history: The South Sea Bubble, Tulip Bulb

Mania, railroad stocks, gold in 1979, the Tech Bubble, residential real estate, etc. These are primeexamples of investment groupthink. To a lesser extent, this same mentality occurs outside periodsof incredible asset appreciation as well and it is particularly evident right now in regard to thepublics perception of the United States Treasury market.

The immensely popular investment idea, namely to short U.S. Treasuries, may be the largestsucker bet in many, many years. Instead, buying longer duration government bonds (U.S, Europeanor Japanese) before the final stage of an epic 30 year bull market could prove to be one of thesmartest trades of the last decade. Although buying Treasuries may or may not be the best trade interms of sheer magnitude of price movement, it will prove to be the essence of investing; findinggenuine value in a loathed asset and knowing when to part company with the crowd. Buying SpringWheat in 2005 or shorting crude oil in the summer of 2008 may prove more financially rewarding,

but buying government bonds will be more satisfying since very few believe in a potential advance.

In 2009, the debate between inflation and deflation was fierce. Now it seems the generalpublic agrees that inflation hides around the corner due to massive money printing. Marc Faberenjoyed comparing the United States to Zimbabwe and stated that Ben Bernanke appears to haveRobert Mugabe as his mentor. So far, we have seen little evidence of any inflation; instead on thecontrary, prices have been falling. According to Bloomberg the financial crisis eradicated almost$14.5 trillion dollars in wealth compared to the almost $3 trillion spent in bailout and stimulusprograms. Three trillion has not been nearly enough to cause hyper-inflation in this environmentcompared to the contraction in credit and wealth. The monetary base has exploded, but so hasreserve bank credit. The money isnt getting out to the economy, and the velocity of money (animportant component to inflation) continues to shrink.

David Rosenberg, Chief Economist and Strategist of Gluskin Sheff recently presented someinteresting data in regard to the average U.S. household balance sheet. The data shows that U.S.households own $800 billion in Treasury notes compared to $3.5 trillion in corporate bonds andmunicipal paper, $4.6 trillion of consumer goods, $7.7 trillion of deposits and cash, $18.1 trillion ofequities (after the bear market) and $18.2 trillion in residential real estate (after three years ofdropping values). A quick back-of-the-envelope calculation from that data shows that Treasuriesmake up less than 2.7% of total household liquid (excluding consumer goods and residential real

8/14/2019 Shorting U.S. Treasuries, a Historic Sucker Bet

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MKC GLOBAL IVESTMENTS, LLC

March 11, 2010

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estate) assets and less than 1% of total assets. Treasuries are clearly under-owned, especially in theface of another downturn in equities when investors will demand safe assets.

For many years now, traders and portfolio managers have been salivating at the idea of

shorting Japanese Government Bonds, citing the countrys high debt to GDP ratios and history ofquantitative easing. Japan is the real world proof that U.S. and European government bonds cancontinue to move significantly higher and yields can move much lower than anyone thoughtpossible, even in the face of what seems like unsustainable government debt. JGBs rose to a high in2003 and that high is about to be challenged again. That high in bond prices saw a correspondinglow in yields of 1.049%. If the yield on U.S. 10 year notes drops to the same level the bond pricewould rise to approximately $146.00, a 24% rally from current levels.

Some trades are good enough to assume just from a contrarian standpoint. The basics of acontrarian play is that when everyone moves to one side of the trade, there are so few new buyers(or sellers) to get on board and maintain the price movement that prices will swing the other way.The case for a contrarian trade in government bonds is perfectly clear. CNBC and Bloomberg

routinely have guests and analysts making their all too common case for shorting governmentbonds. The financial gurus (some of which I respect very much) like Jim Rogers, Marc Faber, PeterSchiff and Nasim Taleb all preach the same trade. In fact, Mr. Taleb recently stated that everyhuman should short U.S. Treasuries, a statement he will most likely regret for some time. Financialmagazines such as Smart Money and Forbes have published feature articles about the Treasurybubble and impending high interest rates. Many financial bloggers and small speculators love thistrade as well, typically citing the previous sources for their research. Even Pro Shares launched twoUltra-Short Treasury ETFs in early 2008, which would rise in value if U.S. Treasuries declined. Itseems that all components of a contrarian trade exist. At some point all these market participantswill be absolutely correct, government bonds will decline dramatically and interest rates will rise.They are not wrong, just too early.

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