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I've passionately argued against bailouts, government intervention and entitlement spending for a decade. But unlike the protestors blocking traffic in New York, my brand of vigilantism involves trading, not occupying.
Bond market vigilantes protest destructive, inflationary fiscal policy by selling bonds short and betting on higher interest rates. As inflation rises, investors expect higher yields because a bond yielding 2% is nearly worthless when inflation is running at 24% a year, as it is now in socialist Venezuela.
It's been nearly thirty years since the United States has experienced significant inflation. Yet with yields on bonds already at historic lows, any meaningful inflation, or heightened concerns about U.S. creditworthiness, could quickly fuel a jump in yields and losses for bond investors. A 3-point rise in interest rates would equate to a 23.5% loss for benchmark 10-year bonds and a 40% drop in long-term Treasurys, according to data from money manager GMO.
With government figures promising that inflation remains low -- and the Federal Reserve employing various mechanisms like quantitative easing and "Operation Twist" to keep rates interest rates down -- it's easy to be lulled into a false sense of complacency.
Yet like most market trends, interest rates can move longer and more persistently than anybody might imagine once momentum is underway. In Portugal, 2-year notes yielded less than 5% for years before jumping as high as 20% just a few months ago. From 2006 to 2010, Greek short-term yields rarely exceeded 4% before rising as high as 75% just last month. Both inflation and fears over creditworthiness have prompted investors to ditch bonds from European PIIGS.
In the U.S., however, interest rates have dropped: the 2-year note which yielded 5% in 2007 now earns a mere 0.25%, meaning $1 million in savings now generates an income of roughly $208 a month, compared to the $4,166 it earned in 2007.
Rather than protest the Fed by banging drums and blocking traffic, I'm joining the financial market vigilantes by adding shares of US Treasury 2-Year Bear ETN Profile (DTUS), one of the only domestic ETFs that offers inverse exposure to short-term government debt. If short term rates rise again, so will this fund.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC
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