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How to Profit from Rising Interest Rates

Interest-Rates / US Interest Rates Feb 11, 2011 - 05:16 PM GMT

By: Terry_Coxon

Interest-Rates

Best Financial Markets Analysis ArticleTerry Coxon, The Casey Report writes: In the fall of 2008, the Federal Reserve responded to the Lehman bankruptcy by igniting a rapid expansion in the U.S. money supply. It did so because, by its lights, the immediate and obvious menace to the economy was a deflationary collapse, with one giant bankruptcy breeding another. And it went about the task without compromise; the monetary base more than doubled in less than a year, and the public's M1 money supply (checkable deposits plus hand-to-hand currency) jumped by 20%.


To some investors, including many of the editors at Casey Research, this policy seemed to guarantee price inflation sooner or later – which, when it came, would mean higher interest rates and falling prices for long-term bonds, including Treasuries. Or, as a speculator would put it, when the time comes, a lot of money can made by shorting T-bonds.

But "sooner or later" is a nearly useless foresight. So far, as Treasury bonds were concerned, the fear brought on by the bursting of the housing bubble, tumbling stock prices, the near-death experiences of large financial institutions, and the well-publicized bailouts of public companies trumped any concerns about inflation somewhere in the future. The compelling desire, especially among institutional investors, was to escape default risk, and that meant buying Treasuries. Inflation was a hypothetical event that could be dealt with later.

For investors who've followed the inflation-vs.-deflation debate and who've come down on the side of inflation, shorting Treasuries looks like a sure thing – and has looked that way for the last two and one-quarter years. But for investors who acted sooner rather than later, results have been disappointing. Every time rates started to rise, bad news from somewhere would revive fears of everlasting recession, a new wave of defaults, or a tumble into the deflationary abyss. Housing prices would take another step down. The reported unemployment rate would stall or rise. The specter of a default in the sovereign debt of a European country would reappear. And every time, whatever the problem, it would stimulate flight-to-safety demand for U.S. Treasury securities. So there was no sustained rise in T-bond yields.

Shorting an investment has costs. In the case of a bond, even if the price stands still, the cost of maintaining a simple short position is the difference between the yield on the bond (which the short-seller must pay) and the yield on the cash that is credited to the short-seller's account. You can't dodge that cost by using futures, options, or an exchange-traded fund. Regardless of how the instrument is put together, the performance will reflect the cost of a simple short sale. So while the investor who bet on rising T-bond rates as soon as the Fed turned on the printing press didn't get whacked by the behavior of bond prices, he did suffer a substantial, ongoing leakage.

Stacking the Deck

If you were one of the earlier investors, you may have already thrown in the towel. With the meter running, being early doesn't feel much better than being wrong. But I believe that the mere passage of time plus the accumulation of inflationary forces (also known as "stimulus") has stacked the deck in favor of shorting Treasury bonds as a timely move. Later is now. Here are the reasons.

  1. The government has actually done what it said it would do. It has run trillion-dollar-plus annual deficits, and it has bloated the M1 money supply. (That's the accumulation of inflationary forces.)

  2. With QE2 (the second round of money creation and attempted interest-rate suppression), the Federal Reserve will be doing more of the same at least into the middle of 2011. And with the current federal budget plans, the Treasury also will be continuing on the path it set upon late in 2008.

  3. Inflation is starting to look overdue, which increases the chance that it's not too far away. The effects of money creation don't follow a tight schedule – moving more like a jitney than a metronome. But on average, a burst of money creation will have its peak effect on economic activity 9 to 18 months later, and the peak effect on price inflation may not show up until a year after that. It's now two and one-quarter years since the monetary burst began.

  4. The stock market has been doing what it usually does before economic activity starts picking up – it's been rising.

Does this add up to a sure thing of rising yields and falling prices for Treasuries in 2011? No. But it does stack the deck, which is all a speculator can ask for.

How It Might Look

If a rise in T-bond rates is what lies in the near future, there are three ways it might play out.

The first is a gradual but persistent rise. As the economy recovers, so does the demand for loans, so interest rates on all types of credit instruments, including T-bonds, also rise. And as the fears of 2008 and 2009 become more distant, the public leans more and more toward spending the excess cash the Federal Reserve has created, so inflation picks up. And keeps picking up. So interest rates keep rising.

The second possible pattern is a sudden jump in interest rates as investors seek to dump dollar-denominated bonds. The triggering event might be a new war that guarantees even bigger federal deficits or an announcement from the Federal Reserve that it is considering QE3. As we've seen with the serial sovereign debt crises in Europe, a flutter from any not-so-white swan can set things off.

And, of course, the rise in interest rates could begin with the first pattern and then jump into the second.

How It Might Be Interrupted

The dollar is still the world's currency, the U.S. Treasury still looks like the world's most reliable sovereign borrower, and by the standards of most of the world, the U.S. still looks like a haven of stability. So any troubles outside the U.S. that didn't directly threaten the U.S. would bring flight-to-safety buying, which would temporarily depress T-bond rates. Or an actual default by Greece or any of the other popular candidates for sovereign bankruptcy would, for a while, reverse the rise in Treasury bond yields. A major war that the U.S. stayed out of (if you can imagine such a thing) would have the same effect.

Any such setback for short-sellers of Treasury bonds would be short-lived. The reason for expecting a rise in rates isn't the events that lie ahead. It is the money creation and the deficits that have already occurred.

How to Place Your Bet

The most efficient and reliable way to speculate on rising interest rates is something most investors don't want to do – use the futures market. If you do take that route, I suggest shorting the 10-year T-bond. That's the maturity the Federal Reserve is targeting with QE2. There is no better way to boost your odds than to short the bond whose price the government is trying to support. The fire-and-forget strategy would be to deposit sufficient margin (as required by the particular broker you trade through) to keep your position open even if the rate on the 10-year bond falls back to 2.4% – which is the low since 2007. That's the simple and cautious approach. It would limit your leverage, but it also might improve your sleep patterns.

The more convenient way to speculate on rising interest rates is to use the Rising Rates Opportunity 10 ProFund, which is a mutual fund that tries to emulate a non-leveraged short position in Treasury bonds. Such funds have an unavoidable shortcoming: maintaining a 100% short position in anything isn't easy when capital is flowing into or out of the fund every day. This may make an investment in fund shares more profitable or less profitable than a short position in the futures market that you establish for yourself. It adds another element of uncertainty, like play in a steering system. That's a flaw, but for an unleveraged fund, I wouldn't rate it as a disqualifying flaw since, as I want to make unmistakable, we're talking about a speculation.

[Terry Coxon is a contributing editor to The Casey Report, Casey Research’s flagship advisory for big-picture investing. For a very limited time, you can now get one full year of The Casey Report for only $98 – that’s 72% off the regular price. Sign up risk-free, with our 3-month money-back guarantee. But hurry, this offer ends soon… details here.]

© 2011 Copyright Casey Research - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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