I generally prefer to write about emerging markets, as I am confident that with sound long-term fundamentals, even the most severe corrections will turn out to be buying opportunities.
But the shocks emanating from the developed world do affect my favorite emerging markets and cause shakeouts that have to be handled properly from a tactical perspective. And it appears that the problems in Europe that caused one such sharp correction in the April-May period of last year are again intensifying.
I am following the European situation closely right now, as I believe that the euro currency has a very slim chance of surviving in the next decade. As I write, Greek credit default swaps price in a 65% chance of a default in five years, while euro-denominated 10-year Spanish government bonds have sold off to yield 5.6%. U.S. Treasurys of the same maturity yield 3.37%, very similar to euro-denominated German bunds — the benchmark risk-free rate in Europe.
I find it very peculiar that on a day when Standard and Poor’s puts U.S. Treasury debt on watch for a possible downgrade — meaning a 33% chance for a ratings cut within two years — those very bonds reacted positively. The selling in Treasury bonds was fast in the morning when the S&P news broke, but they recovered all losses and clawed their way back into the green.
So, while I do agree with PIMCO’s Bill Gross that the U.S. federal government is “out-Greeking the Greeks” with trillion-dollar deficits as far as the eye can see, that is a strategic consideration for long-term holders of Treasury debt. If you are looking for a short-term tactical trade, June call options on the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT) look quite a bit more appealing than any bearish trades.
You don’t short U.S. Treasury bonds because of bad long-term fundamentals at a time of an intensifying sovereign debt crisis in Europe; this is precisely when you buy them, even if it is for a short-term trade. You can short them all you want when the coming Spanish sovereign debt crisis is over.
To get the biggest leverage to an upside move in the Treasury market you need to have the biggest duration, or highest sensitivity to a drop in longer-term interest rates. That used to be the theory anyway, even though the introduction of QE1 and QE2 certainly mispriced risk and twisted bond prices in ways never before seen in the United States.
For example, Fed purchases were concentrated toward intermediate maturity bonds last summer, and as a result, 10-year Treasury notes investable via the iShares Barclays 7-10 Year Treasury Bond Fund (NYSE: IEF) were better performers than the longer duration TLT!
I think both TLT and IEF are likely to surge in an event of sovereign debt panic in Europe that spills over into the Spanish debt markets, and supporting this was a two-year debt auction in Spain on Monday that did not go over well. Both IEF and TLT trade options where bullish strategies like June at-the-money calls or the relevant spreads make sense. The TLT put credit spreads — a bullish strategy — that I suggested in late February worked out to a “T.”
Now, if you want to trade a potential PIIGS-driven spike in U.S. Treasury bond prices, you can do so via the Direxion Daily 20+ Year Treasury Bull 3X Shares (NYSE: TMF) or the Vanguard Extended Duration ETF (NYSE: EDV). TMF is a leveraged ETF, which suggests that it is great for trading, but terrible as a long-term holding due to the reverse compounding nature of such instruments. EDV is an ETF comprised of long-term zero-coupon bonds, the most sensitive Treasurys to a drop in long-term bond yields. There are risks to this view coming from the eventual end of QE2 in June, but this tactical trade should have played out by then.
Signs Still Point to Silver Correction
Taking a quick look back, the short silver miners, long silver trade I suggested last week, which I have been talking about since late March, is working out as mining stocks are literally moving in the opposite direction of the rallying metal. Since last week, we’ve seen a 6% drop in the Global X Silver Miners ETF (NYSE: SIL), while the underlying metal, as represented by the iShares Silver Trust (NYSE: SLV), has climbed more than 9%!
Granted, we had an even bigger divergence in the fall of 2008, but that was at a time of serious stress in the credit markets. While there is some stress in Europe, the situation is not nearly as dire now as it was then.
In my experience, mining stocks tend to underperform metals before a more meaningful correction. This situation has been going on for four months, and it is beginning to accelerate, so something has to give soon. I am only looking for a shakeout of the kind that we saw in January, but the move could be magnified by a 2010-style temporary surge in the U.S. dollar — everyone’s favorite currency to hate — based on the belated realization that the euro is even worse.