The Ultra contract gets futures traders true exposure to the 30-year Treasury bond. The original T-Bond contract included bonds with terms of 15 years or more.
While volume remains comparatively low, investors have been turning to the Ultra increasingly as deflation, not inflation, has become a bigger worry for the economy.
Inflation erodes the value of fixed-income instruments over time as interest rates rise and outpace the gain of appreciation in bonds and similar securities. Conversely, deflation rewards investors with the rates of return on fixed income that outpace interest rates.
But Kevin Ferry, president of Cronus Futures Management in Chicago, thinks all the deflation worry is getting overheated. He finds it troubling that investors are betting on deflation at a time when increasing levels of debt and deficits suggest, instead, that inflation is on the horizon.
"In our view we think it's the final phase of the bond market, and I'm talking about generational," Ferry says. "We are now seeing what no one ever did in the past 25 years—demand for the longest piece of fixed-income paper you can find. They are throwing up their hands."
In Ferry's view, the move to the Ultra represents a capitulation, or a point at which investors become so convinced that the market is going in one direction that they put all bets there.
But at a time when analysts had been predicting just a few months ago the onset of a bond bear market, investors instead have run back to the safe haven of government debt, rattled by the sovereign debt crisis in Europe and stock market instability most notably featured in the May 6 "flash crash."
Ferry himself is unwilling to set a date when the bond market may collapse, taking the contrarian viewpoint that the vast appetite for Treasurys and long bonds is a sure signal the trade is at least winding down.
"There are enough deflationary headwinds, especially with this forced austerity, to think that another grab for duration is not out of the question," he says. "If we start seeing weakness then we will start to act."
Primary buyers for the Ultra bond futures would be pension funds and insurance companies that need to meet requirements for portfolio balance. But Ferry says the greater significance is how the Ultra has led bond market movements.
"It's leading every single market move up when there's trouble and every single rejection when people think things are OK," he says.
The trend toward long-dated bonds is not surprising to those who think the market for Treasurys has been overheated and led by investors who are ignoring inflationary signals.
The trend is "another indication of how bubblicious this market has become," says Michael Pento, chief strategist at Delta Global Advisors in Parsippany, N.J. Pento points out that by 2015 the U.S. will be spending 30% to 50% of all revenue on debt service payments, a factor that will drive up interest rates and push people away from bonds.
"If you have 50% of all revenue going to interest payments, what do you have left?" he says. "You have exploding deficits, you have skyrocketing interest rates, people selling your currency—you have economic catastrophe."
Yet investors keep coming back to bonds, flocking to a two-year auction Tuesday, despite indications that higher rates are waiting on the horizon.
"The amount of debt we're going to be seeing over the next decade is worrisome, the Fed's balance sheet is worrisome. Those are off into the future now," says Kim Rupert, managing director of global fixed income analysis at Action Economics in San Francisco. "At some point something's gotta give and rates are going to turn sky high. It's just a matter of when."
The Ultra also can be used for hedging. Though the interest in shorting, or selling, the futures contract has been slim so far, that could change when the interest rate picture switches.
"With long-term U.S. bonds you're really playing with fire," says Mike Larson, analyst at Weiss Research. "We're still borrowing and overspending and we don't really have a concrete plan to get that down."
As for the Ultra, the contract is still trading at a fraction of the volume that the old T-Bond futures contract sees.
Nevertheless, Ferry says he's seen enough to know that trouble is ahead.
"Everyone wanted a piece of the inflationary theme when the Fed went to quantitative easing. They got killed. So now they're seeing the other side," he says. "That's indicative in our mind of a last-ditch, crazy fifth wave. This is what happens at the end of cycles. We're in that final stage."
©2010 CNBC.com
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