Significant rally in US treasuries capped with Friday selloff

It’s been quite a week for the US Long Bond:

I actually think that the TLT rally we see still has legs to it. There are a number of reasons to expect economic weakness and reduced CPI going forward including the following:

  1. Stimulus programs such as added unemployment benefits are coming to an end. These have already ended in many states but will expire nationally this September.
    1. This includes the extra $300/week payment, as well as the Pandemic Emergency Unemployment Compensation (PEUC), and the PUA programs.
    2. During the Great Financial Crisis, regular unemployment duration was extended from 26 weeks to 99 weeks. The covid response varied state by state, but still added a maximum of 20+26 weeks before expiring completely: Policy Basics: How Many Weeks of Unemployment Compensation Are Available? | Center on Budget and Policy Priorities (cbpp.org)
    3. In short, a large amount of government money that was going into the economy is about to stop. This will force spending downward and put downward pressure on the CPI, inflation expectations, and treasury rates.
  2. Forbearance programs in rents, mortgages, and student loans are also coming to an end. This will divert even more money that previously went into spending.
  3. Inflation measures in the US are based on annual changes. The comparison against the lockdown months is gone, future months will be compared against an economy that combined initial re-opening and massive government stimulus including PPP and stimulus checks.
  4. Dollar shortages are showing up in a number of countries. Many emerging economies responded with interest rate hikes while developed economies responded with some form of tapering of their asset purchase programs.
  5. China just responded this Friday by reducing their Reserve Rate Requirement (RRR). This article explains what they were doing, but I’ll sum up below: How Do You Spell Escalating? C-H-I-N-A-R-R-R – Alhambra Investments (alhambrapartners.com)
    1. US treasury interest rates spiked on Friday when China announced that they were reducing their RRR. The thinking is that this will enable their banks to lend more to stimulate the economy, and that a credit pulse in China could boost commodities and inflation expectations like it did back in 2008 when they were building skyscrapers everywhere.
    2. However, China has done this a number of times in the last decade in for a very different reason; their system is short US dollars. In the 2000’s, China was building up US dollar reserves like crazy, which added a lot of assets to their bank’s balance sheets. They would raise the RRR to lock a lot of this money in the financial system in order to prevent credit spikes and keep domestic inflation under control. Now the process is simply going in reverse; China needs to alleviate a domestic dollar shortage by selling US treasuries, which will reduce the assets on their bank’s balance sheets, and they don’t want this to create a domestic credit freeze as their banks hit the old RRR limits.

In short, I expect interest rates in US treasuries to continue lower throughout the year and I wouldn’t be surprised to see weakness in stocks and commodities.

So why did I reduce my position so heavily? In short, because I was over-allocated. Look at my allocations from my posts in February – I jumped in too fast putting nearly half my portfolio into TLT calls, and I got killed as rates moved against me. This over-allocation prevented me from being able to safely and methodically add as rates went higher. I don’t want to exit the trade completely because I’m still confident in the overall thesis that bond yields will bottom in the next few months – but I can’t responsibly manage an options trade that’s 50% of my portfolio, even if it doesn’t expire for another 18 months.

Whenever you trade on a macro thesis, you have to realize that your trade can turn against you and plan accordingly. It’s better to hold back enough where you can responsibly add as you wait for it to play out, and it is better to reduce a bit on the rallies in case of a head-fake and further weakness down the road.

I’m still nervous about the leverage in the financial system causing problems (it can’t increase forever, right?), so I’m not going to make a long bet on general US stocks. Ironically, I feel more comfortable with the mining stocks mainly because they’ve been missing out on much of the post-covid gains. These are cyclical in nature – bear markets lead to under-investment which leads to shortages which leads to bull markets which leads to over-investment then repeats. The miners (gold, silver, uranium, copper) had a terrible bear market from 2012-2018 and they have just started to recover. I don’t feel as comfortable with Oil because it seems to have shorter production cycles due to fracking technology, and OPEC can always increase supply.

As for emerging markets, I remember being over-allocated to them back in 2008-2009 with de-coupling and all that. I learned that EM stocks get hit hard on developed market weakness as foreign investment turns risk-off and rushes back home. Then they miss the initial upside after a bottom (like 2009) but they rally hard on the growth part of the cycle that follows. I’m still short EEM, and I fully expect the same cycle to play out. If the US stock market seriously tanks, then stabilizes and starts to recover, then I will allocate to emerging markets and not before.

For now, I think I’m over-allocated to precious metals miners so I will try to refrain from adding there. Same goes for copper – I have more than I need with NOVRF plus the exposure in my other mining stocks. I would still like to add to CCJ (uranium) on weakness, and I do expect to see more weakness this month. I’m thinking about just sitting on a stronger cash position when I close out my TLT calls. Maybe I’ll get a few more long-dated index puts if we continue to hit all time highs in IWM & QQQ in coming months …. but I’ve lost so much doing that these last 18 months that I’m not too sure about that one.

Anyway, my portfolio was actually up slightly on the week. Here’s where it landed:

  • DOWNSIDE BETS (36.9%)
    • 26.1% TLT Calls
    • 5.5% IWM Puts
    • 3.4% QQQ Puts
    • 2.0% EEM Puts
  • PRECIOUS METALS (42.9%)
    • 9.8% AG (Silver), mainly shares some calls
    • 8.1% SAND (Gold, Silver & others), all calls
    • 5.5% EQX (Gold), shares & calls
    • 4.7% SILV (Silver)
    • 4.3% MTA (Gold & Silver)
    • 3.2% SILVRF (Silver)
    • 3.0% LGDTF (Gold)
    • 1.5% WPM (Gold, Copper & Silver), all calls
    • 1.5% RSNVF (Silver)
    • 0.6% SSVFF (Silver)
    • 0.7% GOLD (Gold, Copper), all calls
  • OTHER COMMODITIES (8.3%)
    • 4.7% NOVRF (Nickel/Copper)
    • 1.7% UUUU (Uranium, Vanadium, Copper)
    • 1.1% CCJ (Uranium)
    • 0.8% BQSSF (Uranium)
  • CANNABIS (6.3%) split btw CRLBF, GTBIF & TRSSF
  • CRYPTO (3.4%) all ADA
  • CASH (2.3%)

I really don’t know what to predict going forward these next couple months. I could just as easily see gold re-test the recent lows around 1670 as I could see it swiftly rally back to 1900 resistance. I could see IWM and QQQ stocks crash big time in a major de-leveraging event, go through a minor 5% correction, or continue hitting all-time highs. All I know is I’m feeling a bit cautious. Good luck and happy trading.

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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