Martin Sumichrast – Federal Debt May Provide An Investment Opportunity

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I have been talking for years about to ticking time bomb of the exploding Federal Deficit, which now stands at over $16 Trillion. Just to give you some idea, when I launched The Sumichrast Report in 2008, the Federal Debt was $10.1 trillion. We will add $1 Trillion again this year and probably next. Washington is spineless and can’t seem to come together on any real solutions to deal with this problem.

One thing is for sure, it will catch up with us. And when it does, do you really think interest rates will be where they are today?? In fact, when I ask my colleagues about their views on interest rates, virtually everyone believes that interest rates will be higher one year from now. So do I.

The question is how can we make money on this assumption? The obvious and most simplistic answer is to short US Treasuries. This is not easy for the average investor.  However, ETF’s do provide an easy (albeit uncertain) option. Take for example the TBT’s, which are the ProShare ETF which is a 2x inverse on the 20Yr Lehman Bond price. I have been following this stock for over a year and have been trading it with some success.

The inherent risk on the TBT is that like most ETF’s its value slowly shrinks over time. I’m not really sure what the annual percentage actually is…some experts have told me 10-15% a year, some have said 2-3% a year. After looking at the correlation of the 20 yr prices to the TBT prices going back to the launch of the TBT in early 2008, its very difficult to draw a parallel. For instance, in December 2008, the 20 year was at 3.35% and the TBT was at $35. Today the 20 year is about 2.85% and the TBT is approximately $19. This suggests an inherent loss at the higher end of the scale near 15% per annum. Check out the Department of Treasury link to look up all historical data points at : http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2012

With that said, lets assume that the TBT will be worth 15% less in one year. So the stock you are buying now at $19 is actually worth $16.15. However, the 20 yr is at 2.85%, so to break even, it would have to go above 3.27% to reach break even if you bought the TBT today at $19 and held it for a year. To give some perspective, a year ago today, the 20yr was at 4.35% or a staggering 52% higher!!

Do I believe the 20 yr will be at a 4.35% next April? I am fairly confident that it will be close to 4% if not higher. With that said, along the way, we may get dips that beg for a buy signal, which is what happened in December 2011, when the 20 yr hit 2.48% and the TBT’s hit $17.48. I “backed-up the truck” as we say, and flipped out of my position when it rebounded a few weeks later.

My advice would be as follows (based on a hypothetical investment of 1,000 shares):

1) If the TBT’s go below $18.50, take a position of 200 shares.

2) If they dip below $18.00, add another 300 shares.

3) At $17.50, I would add the final 500 shares.

This averages you out to $17.85 and puts you in at a real strong position to benefit when interest rates spike up (particularly long term rates after June, when the Fed’s “Operation Twist” is set to expire).

For those of you that like to buy Options, look at the TBT Jan 13 $20 calls, which are priced today at around $1.85.

Finally, for full disclosure, at the time of this writing, I have no position in the TBT’s, but I’m watching and waiting.

 

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