On Dec. 23rd, Justice said treasuries could break hard coming into the new year – and they did. But if you’re short, should you stay short... take the money and run... or switch to the dollar instead?

Has the U.S. Treasury bubble popped? It’s starting to look that way.

USTs gapped higher in mid-December, traded in a quiet range til year's end, and then immediately went into freefall with the start of the new year.

This wasn't a total surprise. On Dec. 23rd, in a Taipan Daily piece titled "A Treasury Bond Mystery and a Currency Clue," I gave a summation of what was happening and how to play it:

Based on end-of-year accounting factors and a supply-limited window of foreign investor buying, USTs could be a good candidate for a quick, sharp break (much like the dollar's swift fall) early in the 2009 calendar year.

An aggressive put option trade – near-term firecrackers relatively close to expiry – could be one way to play this. If done right, it’s the kind of trade where you either lose the small amount you invested or make five times your money in a fingersnap.

There were multiple trading days available to follow up on that hunch. If you chose to act on it with near expiry options as I suggested, you should be sitting on some very nice gains right now.

With that in mind, I still stand by the rest of what I said in that piece:

If I were to make a short-term play like this, I would do it with money I could afford to lose – probably no more than one or two percent of my total trading account. And if the trade paid off, I would take the money and run at the first sign of stabilization (rather than waiting around for the Fed to bid bonds up after the break).

The Yogi Berra Effect

Now, it may well be that treasuries keep tumbling. But this isn’t a trade I would look to build on... at least not for now. As I said two weeks ago, I’d pocket the cash sooner rather than later.

Why? For one, the play just feels too damn obvious now. Everyone and their brother “knows” treasuries are overvalued.

That kind of consensus makes me nervous as a long-tailed cat in a room full of rocking chairs, and Barrons heightened the feeling by putting USTs on their Jan. 5th cover. Get Out Now! the Barrons headline blares.

“The bubble in Treasuries looks ready to pop,” the lead piece goes on to add, “sending prices on government debt sharply lower.”

With the whole Barrons yelling “Get Out Now!” bit, I can’t help but think back to some famous old Economist covers, two of which I have framed. “Drowning in Oil” and “The Disappearing Dollar” both marked major trading bottoms. When a view becomes conventional wisdom – or popular enough to merit cover treatment – odds increase that the news is fully discounted.

It's the Yogi Berra effect, slightly modified for markets: "Nobody's in that trade anymore, it's too crowded."

Reasons to Be Wary

Another factor that makes me nervous, as I also mentioned in December, is the Fed.

Falling treasuries mean rising interest rates. The Fed doesn't want rising interest rates... especially when the central banker worry du jour is deflation.

And speaking of deflation fears – which are tied to factors like forced saving, canceled business, and overall economic contraction – how about the recent ISM data?

As the above FT chart shows, ISM readings for both new orders and prices paid just hit their lowest levels in more than half a century. Evidence further shows that manufacturing has slowed markedly all around the world.

In other words, the threat of global slowdown still looms large. If the current market rally is just a trading rally – which can’t be ruled out – then treasuries could head back up again.

The Dollar is a Three-Time Loser

So despite the recent downside action – which was predictable based on end-of-year accounting factors – USTs still have a few things going for them. The Fed could yet intervene in a big way if treasuries fall too far, and investors could scurry back into USTs if the new year trading rally fades.

The U.S. dollar, on the other hand, looks like a three-time loser to me. Consider:

• If the Fed intervenes to support treasuries (in order to keep interest rates low), they will do so at the expense of the greenback. The Fed has to print dollars, or otherwise release dollars, in order to buy USTs in the open market.

• The powers that be (a.k.a. the Fed and Treasury) are implicitly supportive of strong treasuries (per the stimulative effect of lower interest rates) and a weak currency (also stimulative for exports).

• Whether the global economy rises or falls in 2009, the U.S. dollar no longer benefits from the foreign investor inflows that were once so strong.

In the “good old days,” when Americans were buying shiploads of “stuff” on credit from China – and paying with mountains of paper dollars – China happily recycled those dollars back into U.S. assets: equities, treasuries, mortgage backed securities, stakes in private equity firms, and so on. All this recycling was supportive of the greenback.

The same thing happened with the oil bought on credit from the middle east. The paper dollars sent to Saudi Arabia, Abu Dhabi and so on came right back home in the form of large purchase orders for dollar-denominated assets. This recycling factor kept the game going.

Now those U.S. dollar props are history. China's risk appetite is shot, the oil exporters are no longer flush, and all parties are aware that the Fed wants a weakerdollar, not a stronger one, in order to stimulate U.S. exports and encourage local spending choices.

Multiple Scenarios

For these reasons, I am looking to build a sizable short U.S. dollar trade in the near future. I like the fact that a falling dollar is a probable outcome in multiple scenarios.

For instance, if the global economy bounces back in 2009: Emerging markets outperform, banks begin to lend, the Fed’s “quantitative easing” prescriptions kick in with a lag... and the dollar falls.

If the global economy gets worse: The new year equity rally fades, treasuries move higher, the Fed takes even more radical measures with its “quantitative easing” plan, the trillion-dollar stimulus ceiling is shattered... and the dollar still falls.

If the global economy gets much, much worse: Foreign holders of USTs get nervous and start dumping all remaining dollar-denominated assets... the Fed loads up on treasuries as a desperate buyer of last resort to keep interest rates low... and the dollar flat-out crashes.

You get the idea. There are certainly “dollar up” scenarios one could concoct, but in my view they are outnumbered by “dollar down” at least three to one.

In light of all this, I’ve been keeping an eye out for a tactical point of entry ever since the dollar’s sharp break a few weeks ago.

Based on the old trading truth that failed breakouts are some of the most convincing signals, we could see an excellent short-side entry point if – and it’s important to note the “if” here – the USD follows through on a reversal-type failure to the downside.

I'm curious what you, the Taipan Daily readership, thinks.

Do you have any T-bond or forex positions on (or plan to put any on)? Did you act on my Dec. 23rd hunch? Would you be interested in hearing more on currencies, futures and the like? Inquiring minds want to know: justice@taipandaily.com

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