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Buy U.S. Treasurys One Last Time

Play the short-term upside in Treasurys with these funds

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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.”

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