News Analysis date published New: 
Monday, July 9, 2012 - 14:30
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Monday, July 9, 2012 - 14:33
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Monday, July 9, 2012 - 14:30

The Best Way to "Fight the Fed" -- and Possibly Make 30%

Monday, July 09, 2012 2:30 PM

The biggest trades are the ones no one sees coming. Take housing in 2006. Optimism was at an all-time high. Prices were screaming higher every quarter. The mere mention of a correction brought immediate scorn and ridicule. Until the day prices began declining, very few people could have imagined housing prices would experience a meaningful pullback. Or how about the financial sector and bank stocks in 2008? The most bearish forecasts didn't anticipate a Lehman Brothers bankruptcy up until the second it happened.

Both of these events were huge market shockers that sent asset prices flying. Anyone shorting housing or financial stocks in those days made a lot of money.

But if you missed those two opportunities, then don't worry. There's another trade setting up right now that will be just as big. Let me explain...

The next big trade
It's happening in the fixed-income market, where the world's largest borrower continues to enjoy record-low borrowing costs in spite of exploding debt and an ever-weakening credit profile. The culprit is the U.S. Federal government, with a debt-to-GDP (growth domestic product) ratio of 102%, well past the key level of 70% that traditionally signals financial distress.

And in spite of the federal government's overwhelming debt load of more than $15 trillion, the trend is expected to accelerate. The Congressional Budget Office predicts this massive debt to increase by more than $1 trillion this year alone. And when you throw in what the CBO estimates as $34 trillion in unfunded liabilities for Medicare and Social Security, the financial outlook for the federal government is dire.

But as far as the U.S. Treasury market is concerned, none of this matters.

Currently trading below just 2.75%, 30-year Treasury yields have rarely been this low. In fact, the idea of the federal government getting into financial trouble and paying higher interest rates has been mocked by some of the highest-ranking politicians and central bankers in the land, including Treasury Secretary Tim Geithner, who notoriously said the United States had no risk of losing its "AAA" credit rating in April of 2011, only weeks before it actually happened.

Smooth sailing has been priced in by the Treasury market, and it's creating a huge opportunity for savvy investors. It comes in the form of ProShares UltraShort 20+ Year Treasury (NYSE: TBT), an exchange-traded-fund (ETF) that increases in value when Treasury yields increase -- and eventually, they will.

This is one of the most popular ETFs in its space, with average daily volume of more than of 7.9 million shares, providing plenty of liquidity. Its expense ratio of 0.93% is only marginally higher than the category average of 0.86%, while its tight bid-ask spread helps ensure that you get a price close to what you order on the market when the trade is executed.

Shares have taken a beating in the past 18 months, falling close to 60% as the Federal Reserve unleashed a number of policy tools to push interest rates even lower.

The trajectory of falling interest rates in the face of growing debt is unsustainable and it's just a matter of time before interest rates go up again.

And a key event could be the catalyst...

The United States is headed toward a fiscal cliff at the end of the year, when the politicians will have to decide whether to extend the Bush-era tax cuts and execute mandatory spending cuts, estimated to be around 4% of total GDP.

Neither party will have any incentive to implement austerity. The politicians will purse the path of least resistance, which is always growth. And when that happens, fueling more deficits and debt, credit rating agencies will be watching very closely. A negative outlook or downgrade on weaker tax revenue will shock the market into re-pricing the risk of owning Treasury bonds.

And then investors who own this ETF will be glad they bought when they did.

Risks to Consider: There is a classic saying in the marker that says "don't fight the Fed." And as it stands, the most powerful central bank in the world is fully committed to doing everything it can to keep interest rates low. This has caused a lot of pain for anyone shorting Treasury bonds in the past two years, with yields falling lower in spite of a rising stock market and positive GDP growth. So by shorting Treasury bonds, investors are taking on one of the most powerful financial institutions in the world with a highly successful history of manipulating interest rates in its favor.

Action to Take --> In the past three years, the Fed has dug deep into its bag of tools to support domestic and global economic growth, pushing yields on U.S. Treasury bonds to rock-bottom levels below 3%. But with a large federal deficit creating a growing debt load, these low borrowing costs are unsustainable. If yields on Treasuries jumped back above 3.45%, where they stood as recently as April before stocks took a seasonal dive, then ProShares UltraShort 20+ Year Treasury would likely jump more than 30% back to its 52-week high just above $21.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.