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The ProShares UltraShort 20+ Year Treasury ETF (TBT) is a leveraged exchange-traded fund that seeks to track the inverse daily movements of ICE U.S. Treasury 20+ Year Bond Index. The fund has about $950 million in total assets, which is primarily held in near-term Treasury bills. The “short” bond exposure is achieved through derivatives in the form of index swaps. The idea here is simple; if bond prices falls, bond yields (rates) go up and TBT will appreciate by -2x the corresponding decline in the price of the benchmark index. While bond prices continue to climb driving yields lower, TBT has been a poor investment. While the consensus is that there is likely more room for yields to fall with the Fed signaling rate cuts into next year, this article looks at four contrarian type of scenarios that could drive long-term yields higher representing significant upside for TBT.
TBT weekly price chart. Source: FinViz.com
Long-Term Rates Background
Unfortunately, betting on higher yields has been a sucker’s game not only in recent years but also going back nearly four decades since the 30-year Treasury bond yield reached 15% in 1981. Declining short-term interest rates over the period, combined with structurally low inflationary pressures and stable inflation expectations, are some of the main factors describing the seemingly endless bull market in bond prices. Technically, accommodative monetary policy among the Fed and central banks in developed markets around the world to support growth has led to lower real rates of returns and a lower return premium at the long-end of the yield curve over the past decade. These are trends that continue today, but are certainly not a sure thing into the future.
30 Year Treasury Rate Historical Chart. Source: Marco Trends
Here are three scenarios that result in an extended move higher in long-term yields. There’s nothing to suggest the 30-year Treasury rate will explode higher or ever reach 15% again, but it’s possible. I think TBT has value here on a combination of technical reasons and trends in market psychology.
1. Economic activity outperforms resulting in a renaissance of growth expectations.
One of the most difficult aspects of investing in my opinion is reconciling potentially conflicting outlooks among different asset classes. That’s the case today with the S&P 500 index just points away from an all-time high, implying a strong outlook for earnings and growth even as falling yields send a conflicting message. According to the current 10-year bond rate and 3-month Treasury bill rate spread, the market implies a 29.6229% of the U.S. falling into a recession by next year. This is data published by the Fed based on parameters observed since 1959.
U.S. Total Public Debt % of GDP. Source: Federal Reserve Bank of New York
Take a step back for a minute and assume the stock market is in fact correct and the recession signals sent by an inverting yield curve and falling rates are just wrong. One scenario that could result in a reversal of these trends and a move higher in interest rates would be a series of better-than-expected economic data forcing the Fed to return to a more hawkish posture. The potential here is that economy heats up with strong non-farm payroll numbers, a bump of inflation pressures, coupled with more dynamic consumer spending trends. A steepening yield curve here would be bearish for bonds and for the purposes of this article would be bullish for TBT. This is really a “kumbaya” scenario, but nevertheless possible and something some bullish equity investors must consider.
2. Dovish Fed commits policy mistake and inflation expectations become unanchored
The word inflation must draw eye-rolls from a number of investors as it’s largely been an afterthought over the past decade. The current annual rate of inflation is 1.8% for the month of May and hasn’t climbed above 3% except for a brief period back in 2011. One of the reasons pulling long-term rates lower has been falling inflation expectations over the past year highlighted by the chart below. The current five-year forward inflation expectation rate implied by interest rates spreads is 1.8%, which is below the Fed’s 2% target. The implication here is that the market expects a widening output gap and slower growth with the weak demand pressure containing consumer prices over the period.
U.S. Total Public Debt % of GDP. Source: Federal Reserve Bank of St. Louis
A scenario that could develop is that the Fed makes a policy mistake by cutting the Fed funds rates too and thereby risking inadvertently overheating the economy. If inflation expectations begin to trend higher, the yield curve would steepen as investors price the bonds to demand a higher real return. This scenario here of higher long-term rates despite a Fed rate cut is driven by inflation which can be difficult to predict and ultimately control. Long-term bonds would sell off representing upside for TBT.
Between scenarios 1 and 2, I believe the Fed is in a difficult position and forced to act reactively to conditions in the yield curve. The next move could have major implications to capital markets and some of those outcomes may be bearish for bonds.
3. Market turns attention to fiscal deficit and rising level public debt
Back in 2011, S&P downgraded the U.S. credit rating to AA+ which turned out to be a fiasco resulting in extreme levels of volatility with the “S&P 500” falling nearly 20% during that period. The agency cited in its report concerns over the fiscal outlook saying it:
Falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamic. More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.
I say fiasco because it was controversial at the time and, according to reports, forced the president of S&P to resign. It’s difficult to justify the downgrade implying the U.S. government has a higher risk of default compared to other AAA sovereigns like Switzerland or Australia. Still, the point here is that S&P was in fact on to something and a widening fiscal deficit and rising debt remain a concern. Total public debt as a percentage of GDP is now above 105%
U.S. Total Public Debt % of GDP. Source: Federal Reserve Bank of St. Louis
The scenario here is a more bearish case that should the economy slow and potentially enter a recession, the prospect is that tax revenues pull back and the fiscal deficit expands substantially. Fiscal stimulus measures and further quantitative easing by the Fed would only exacerbate the situation. Drum-roll and bonds could sell off as the implied credit risk of the U.S. government widens compared to other AAA sovereigns. An environment of a “run-away” deficit and surging debt from the already high current levels could result in a selloff in bonds as investors reprice the long end for higher implied risks.
4. Mean Reversion on the horizon
The 30-year bond yield’s last 52-week high was on November 8, 2018, when it peaked at 3.43%. Considering the current yield of 2.57%, the change represents a decline in the yield rate of 25%. Looking back over the past decade, declines in the yields over 25% over a corresponding time frame have typically represented an inflection point where the bond sold off and the yield rose. TBT could be a good buy here simply as a mean reversion trade. In other words, bond (prices) are otherwise over-bought and could sell off soon for any variety of reasons.
% change of 30-year bond rate. Source: data by YCharts/ author graphic
Note that these types of percentage changes on bond yields are not typically used as metric of comparison, but nevertheless help frame levels with some type of reference point. If the 30-year Treasury rate climbed to 5.14%, that would represent an increase of 100% from the current yield level. On the other hand, a decline to a 2% yield rate would represent a 22% move lower. The 30-year rate bouncing to 2.85% could represent ~15% upside for TBT in the short term.
Data by YCharts
Conclusion
For the record, I am neutral on TBT. A near-term catalyst higher could be a strong June non-farm payrolls figure and a string of other positive economic data. The scenarios discussed above are worth considering and for me at least pulls back some of the current blind optimism that rates are just headed lower. I keep an eye on this ETF because it’s relatively liquid and offers potentially significant returns in an environment of rates trending higher. TBT also has qualities that could be used for hedging purposes against fixed income holding. Another option to trade a bearish view of bond is to consider The ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF), which is the non-leveraged version of TBT. The key advantage in TBT however is that it has higher liquidity trading 1.6 million shares per day, representing $50 million in nominal trading volume. TBF on the other hand is a smaller fund with only about 250k shares traded per day and one-tenth the dollar volume.
It’s curious that TBT as a “short bond” ETF actually has a distribution yield since it holds a portfolio of Treasury bills as collateral against the index swaps that represent the short exposure. The distribution yield is approximately 1.7% on a trailing twelve-month basis.
The ProShares UltraShort 20+ Year Treasury ETF is otherwise an extremely volatile and highly speculative security not suitable for all investors. Take a look at the prospectus published by ProShares for full list of risk disclosures. The expense ratio is 0.89%.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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