BUY TREASURYS...FOR A TRADE

“I love the 5-year Treasury right now,” your editor
declared to his colleagues yesterday during their monthly
editorial meeting in Baltimore. “In fact, I like the entire
yield curve, from three months out to 30 years.”

“Oh! Oh! Oh!…Me too!” blurted Mike Shedlock, contributing
editor of Whiskey and Gunpowder, bouncing in his seat and
waving his right hand like a kindergartener in need of a
potty break. “I love that trade!…I think we’re right on
the brink of a great technical and fundamental set-up for
buying bonds.”

“I don’t know, seems kind of boring to me,” another editor
remarked, failing to catch Shedlock’s infectious
enthusiasm.

“Yeah, it’s boring,” your editor admitted, “but I think you
could make 15% on this trade in one year or less, with very
little risk. But of course, there are many ways to make
this trade much sexier. You could buy options on T-note
futures, or you could buy options on one of the ETFs that
owns Treasurys…or you could do something even sexier
still, like buying long-dated Treasurys against a short
position in a junk bond fund.”

“Ooooo…I like that,” cooed Chris Mayer, editor of Agora’s
hottest-selling investment letter, Capital and Crisis. “You
get to play the spread against the two, which is a
different sort of bet on a slowing economy.”

“Yeah, I like that trade too,” your editor applauded
himself. “The bottom line is that each of these bond trades
relies upon a slowing economy and a moderating inflation
rate. It appears that the U.S. economy is slowing rapidly,
and I suspect the inflation numbers will drop off pretty
sharply over the next two months in line with falling
energy prices.”

…I have not become a bond bull, dear investor, just a
bond opportunist.

“The U.S. economy is much slower than the official figures
indicate,” Dr. Richebacher warned me during my visit to
Cannes last week, “I expect the GDP to be negative in the
first quarter of next year, if not earlier.”

Bond fund manager Bill Gross has been uttering similar
remarks of late. “Our Fed will likely be in the…position
of lowering rates come mid-year 2006,” Gross predicted
recently.

Either these two savvy, independent thinkers are onto
something, or they are both suffering a form of sunstroke
from toiling too long in the beachfront communities they
inhabit – Richebacher in Cannes, and Gross in Newport
Beach.

But if these two men are correct, Treasury yields might
start falling very soon…at least for a while. Interest
rates along the entire yield curve might fall. But since
your editor is more gallinaceous than porcine, he’d prefer
to play this trade at the short end of the curve, where the
risk of error is less catastrophic than on the long end. In
other words, since he’s a chicken, he’d rather buy the 5-
year than the 30-year. Today’s buyer of a 5-year Treasury
yielding 4.30% would do very nicely if yields dipped back
below 3.70%, the level at which the 5-year traded last
June.

The obvious risk, of course, is that the yields will not
fall, but will continue their recent ascent in step with
rising inflation. In which case, the buyer of Treasury
securities would fare poorly. Inflation may, indeed,
accelerate. But it might also wither on the vine as U.S.
economic growth stalls and heads into a tailspin.

Already, the personal savings rate has tumbled below zero,
despite the fact that consumer spending is also plummeting.
In other words, even though consumers are retrenching, they
are still unable to save money. The chart below explains
much of the reason why. Rising energy bills have consumed a
growing percentage of the American consumer’s meager
savings, as well as a growing percentage of his massive
borrowings.

“As a consequence,” BCA Research observes, “this year the
increase in consumer spending on energy will exceed the
support from housing for the first time since 2000. The
corresponding squeeze on consumer purchasing power points
to a slowdown in household spending growth in the months
ahead.”

We agree. Rising energy prices have completely eliminated
the wealth effect – or “wealth delusion” as Dr. Richebacher
would say – that cash-out mortgage refinancings have been
providing for the last several quarters.

But despite this obvious squeeze on consumer liquidity, the
Federal Reserve has continued to jack-up short-term
interest rates, the effect of which has been to place a
financial noose around the necks of many American
consumers. No wonder that so many of us are gasping for
air.

“With the Fed tightening and energy prices high,” one
trader observed, “growth must eventually weaken. In that
environment, yields have to eventually come down.”

The logic seems impeccable. And yet, yields have been going
up, while every member of the FOMC takes a turn “jawboning”
rates higher still.

Raising short-term rates may seem necessary in light of
recent nose-bleed inflation readings. But raising rates
seems utterly unnecessary, if not downright suicidal, in an
economy that is leveraged to the gills, lacks savings and
relies upon inflating assets for its daily bread.

We are worried that the Fed will do what it has so often
done: raise rates too high and for too long, thereby
triggering a recession. We are worried, and yet, we
wouldn’t mind trying to make a buck amidst our
angst…That’s why we like 5-year Treasurys.

And the Markets…

Thursday
Wednesday
This week
Year-to-Date

DOW
10,281
10,414
-6
-4.7%

S&P
1,178
1,196
-9
-2.8%

NASDAQ
2,068
2,091
3
-4.9%

10-year Treasury
4.45
4.47
-4.00
4.41

30-year Treasury
4.67
4.69
-4.00
4.62

Russell 2000
628
638
-6
-3.7%

Gold
$461.30
$464.70
-$8.30
5.4%

Silver
$7.61
$7.61
-$0.20
11.7%

CRB
322.36
326.75
-5.28
13.5%

WTI NYMEX CRUDE
$59.84
$62.22
-$2.79
37.7%

Yen (YEN/USD)
JPY 115.38
JPY 115.30
-1.38
-12.5%

Dollar (USD/EUR)
$1.2016
$1.1995
71
11.4%

Dollar (USD/GBP)
$1.7741
$1.7659
-42
7.5%