Operation twist risks & how to profit by shorting treasuries

As a follow up to my last post it is interesting to add some comments on operation twist which is likely the second major reason why, after fear and safe haven buying, that treasury yields have been recently falling.

Operation twist can only work in my view if the government targets the yield and not the size like they did in QE2 by buying 600 billions, which did not work. But to target the yield by lets say, fixing a goal to reach a 20 or 30 year treasury yield of 2.5% they have to finance the purchases by either printing money or like they say by selling short term bonds. Printing money would not work since it generates inflationary pressures so you can discard that one. Selling short term bonds like Bills or T-notes has a limit since they cannot sell more then what they have and has the problem that it leaves the FED overexposed to long term treasuries that are very sensible to interest rates and inflation causing a big fall in the face value of their balance sheet if they increase just a bit.

The fundamental problem is that they have a limited amount of short term bonds to sell, so targeting the yield and keeping it low for a long time would exhaust their resources and overweight their balance sheet to long term bonds (dangerous). The markets could deduce that the government cannot keep on selling more short term treasuries and that they would eventually have to print more money, which could again generate inflation pressures. And even if they do have the power to keep the long term yield low for some time, they have no power to control the international price of commodities and oil, which is a wildcard that can also generate inflation and force the interest rates to go up making the operation twist a failure since it is very dangerous to keep low interest rates simultaneously with inflation. So in my view the fed has limited powers against this, at most they have temporary powers and consequences like runaway inflation could come back with strength. So it’s not a good plan to start with, dangerous and not effective for long if they do it. It is also not very wise for the FED to buy long term treasuries as expensive as they are because they run the risk of losing a lot of the face value with the slightest increase in inflation severely impairing the FED’s balance sheet. Those treasuries could lose 20-30% of their face value if just a bit of inflation comes, or even more normal to high inflation comes . I do not think the markets or the FED is comfortable with that possibility.

I think its beyond the government power to control inflation and interest rates. They can just partially and for a short period of time control interest rates by buying treasuries but the amount of money needed to do that for a long period would be so big that the inflationary pressures would pop up on the long run. Therefore I do not think they can keep artificially low interest rates, the more they do the more they create a bubble that can pop and deflate with violence, that is precisely why I think a short on treasuries is interesting. The bubble did not disappear it just passed from private to public hands and seems to be specifically in treasuries now. As I see, after a certain limit, the more the government interferes with the markets the biggest the problem.

Nothing is certain, stocks can go to 0 on bankruptcy. You might decide to stay cash but cash can lose 50% of its buying power (or more) with a few years of inflation. You might decide to go long on bonds but they can lose its value, due to inflation or credit issues, gold can fall or go up, anything and everything has a risk. Whatever action or inaction you take is risky, as long as you are more often right in your analysis and on your estimations of the risk reward odds you should do OK, also as long as you don’t put all your eggs in one basket and you have the right character to avoid falling trap to your emotions and you keep them completely out of your investment decisions.

I’m basically sure that given the huge amount of debt and printing of dollars a 3% yield on 30 years treasury bonds is unsustainable on the long term so I act on that based on a specific and personal risk reward scenario assessment, and committing a percentage of my funds based on that, of course the possibility of a 20 year recession exists, but I think its very low, therefore the risk of not acting could make me lose much more if I decide to stay fully on cash due to a highly likely different scenario.

You can always buy a cheap TLT call options strike 150 to hedge against the unexpected black swan or extremely unlikely of TLT doubling. But note that the black swan could also be on the other side (big inflation) meaning that you would be better of in that scenario by shorting treasuries or buying cheap puts (a la Seth Klarman). Note that treasuries to double 1.5% yield on 30 year treasury bonds would be needed which has never happened historically, but for treasuries to fall substantially just a 5% yield is necessary, which is under the historical average.

To profit from a treasuries short you can scale the sales and do not forget to leave a lot of cash on the sidelines to avoid margin problems, to short more if it keeps on going up and to diversify with several stocks if the opportunity arises since if treasury yields do really fall stocks will more likely become much cheaper. In that scenario one good thing is to have housing construction stocks, since if yields temporarily stay low mortgage rates will be low and can cause a massive amount of refinancing or help potential new buyers to profit from the record low rates to buy a house. So any temporary paper loss on treasuries could be mitigated by an increase in housing related companies. The latter is basically my strategy.

Cheers !
jrv

About jrv

I was born in Spain and lived in Belgium, Chile, France, USA, Argentina among other places. Currently I am trying to settle down in a wild place. I am "retired", even though now I dedicate more hours "working" for my investments than I ever worked in the real labor market where I used to work in IT and Banking. I am a family man, I have a lovely wife, several sons and one step daughter. I have humble tastes, I like to stay home and read about companies and investments. I started investing at 25 before the internet bubble exploded. I did not know much about investing and liked technical analysis so my results were pretty bad. Fortunately I did not have much to lose. Some years later in 2006 bored of doing only real state investments and with quite a lot of money saved I opened an account in a cheap and excellent online broker and started again. This time I did not want to commit the same mistake, so I decided to follow a model. I heard that Warren Buffett was the best at making money via stocks so I started by reading a lot about him, all of his shareholders letters and several of the books that he recommended. I learned a lot, started applying his investing principles and reading a lot of 10K's. Digested news from lots of different sources. Basically I started buying very good and cheap companies and holding them for ever if possible and if nothing changed fundamentally. When the housing crisis started I was more than 75% cash. At that time I identified good companies at incredibly cheap prices so I invested most of my savings in stocks. In less than I year I doubled. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. My wife and I decided to change our lifestyle and moved from Belgium to the beach in a wild country. The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return but specially to move away from the inhuman life of civilization and to have finally some peace and sunny weather to concentrate better on investing. Now I can think and study about companies 60 hours a week and I am doing great. I can finally do what I want full time and can proudly say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! You can learn a bit more about my portfolio by viewing it at www.kuchita.com/view/sumo.php or you may learn more about me and my family by following the link "Author's site" from the menu above.
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3 Responses to Operation twist risks & how to profit by shorting treasuries

  1. Pingback: Shorting treasury bonds becoming serious & other weekly comments | The Intelligent Investor Blog

  2. Nick says:

    Hi
    1. you said:”If you have time on your side, you can handle any vxx spike, the trick is to never let a vxx short position become more than 5-10% of your portfolio (5% when you first short and 10% when the market bottoms) so that you can handle an increase by a factor of 10 without margin calls”
    If you start with 5% and VXX spikes 10 times, it is now 50% of your portfolio.
    How do you never let a vxx short position become more than 5-10% of your portfolio?
    Covering the short gradually is like what XIV is doing, with poor long term results.
    2. you also wrote “So it is ideal to short at that time and simultaneously hedge the short.” (of VXX). How do you hedge a short VXX exactly?
    thanks.

  3. jrv says:

    Hi Nick,

    You refer to this post: http://investing.kuchita.com/2011/08/21/vix-vs-vxx-historical-graph/

    As I mentioned in the post that was written by one of my readers, who is also invested in VXX, I guess he should have more correctly said to never put more than 5% in your short so that if it becomes bigger you don’t run into trouble, so never more than 5% to start with.

    I (and he) hedged by buying calls so if the short goes wrong the calls appreciate and if it goes down I can profit but it has to go down more than if you do not hedge to cover the calls costs, anyways its worth doing, specially if you shorted when backwardation was still strong.

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