Hedge fund legend Julian Robertson is betting the farm against long-dated US Treasurys. As Notes readers will be aware, we have been banging the drum on the vulnerability of long-dated US debt for over a month now. But Robertson, of Tiger Management fame, has a different way to make this short long-term Treasurys play (hat tip Market Folly).

Robertson is shorting long-dated US debt using something called a steepener swap play. Although the mechanism of this trade may be unfamiliar, at heart it’s a simple bet on inflation.

Robertson reckons inflation could easily hit 7% and that it could even reach 18%. Again, Notes readers will be familiar with this market script. This from eFinancialNews:

Steepeners are a type of interest rate swap, where one party agrees to pay the other a fixed rate in exchange for a floating rate, which is derived from the difference between long and short term rates. Many of these products also use high leverage, where the difference between the two rates is multiplied by up to 50 times to produce a higher return.

Retail investors can make the same play as Robertson without using interest rate swaps. It’s actually very straightforward.

Robertson is betting on the yield curve steepening. This happens when the difference between the yields of short-term and long-term US Treasurys increases. Robertson is essentially short the price of long-term US Treasurys and long the price of short-term US Treasurys.

Anyone with a brokerage account can do this by buying the iShares Barclays 1-3 Year Treas.Bd ETF (NYSE: SHY) and shorting the iShares Barclays 7-10 Year Treas.Bd ETF (NYSE: IEF). This would give you a leveraged return on an inflationary future, which not only Robertson but also many other underground investors we know are betting on.

Robertson reckons China and Japan will stop buying US government debt as the dollar weakens. This would bring down the price of 10-year T-notes and cause the yield to shoot up.

Of course, the reason Robertson is so sure that inflation is on the horizon is the Fed’s quantitative easing ‘solution’ to the economic crisis, aka the printing money route, combined with the enormous pressure on US Treasurys right now.

I’m amazed at the amount of money the government is throwing at this thing. You don’t even react anymore unless somebody’s talking about $1 trillion. I genuinely admire the administration’s courage in doing what it’s doing, but not the wisdom of it. I look at the TALF (Term Asset-Backed Securities Loan Facility) program, for example, and it’s almost a bribe to get people to put on more leverage … I ask anyone to give me an example of an economy beefed up by huge amounts of quantitative easing that did not inflate tremendously when or if the economy improved . I think what we’re doing now will either fail, or it will result in unbelievably high inflation – and tragically, maybe both. That would mean a depression and explosive inflation, which is frightening.

Even the mainstream media has started to pick up on the threat of inflation. How can you hedge against it other than by shorting long-dated government debt? Here’s what the Wall Street Journal recommends:

1. A managed gold fund such as Tocqueville Gold (TGLDX) or US Global Investors World Precious Minerals (UNWPX). This is a lower-risk alternative to buying gold directly, since the metal itself can be volatile.

2. A mutual fund that bets on long-term interest rates rising. The two best known are the ProFunds Rising Rates Opportunity fund (RRPIX) and the Rydex Inverse Government Long Bond Strategy fund (RYJUX).

3. An absolute return fund that can use derivatives and aims to beat inflation. An example: MFS Diversified Target Return (DVRAX), which aims to beat inflation over 5% a year over a market cycle. The problem: there are no guarantees. Many of these funds are new. And the track record is too short to judge.

4. Refinance your house into a new 30-year fixed mortgage immediately. Rates currently average about 5.32%. If inflation surges, rates will too.

5. Sell long-term bonds. A bond guaranteeing 7% a year for 30 years won’t be worth much if inflation hits 10% and CDs start paying 11%. Treasury bonds have sold off sharply. But corporate bonds haven’t. The yield gap between long-term investment grade corporates and 30-year Treasurys, which was nearly 5% in mid-January, has fallen to 3.5%.

6. If you want guarantees, buy inflation-protected Treasury bonds (TIPS). Right now, the 20-year TIPS yield is about 2.4% over inflation.

This from Money Morning:

The U.S. Treasury Department announced Nov. 3 that it intended to borrow a record $550 billion in the fourth quarter. That represents a staggering $408 billion increase over Treasury’s borrowing estimate from early August and includes $260 billion for the recapitalization of U.S. banks.

Make no mistake about it: There will be enough U.S. Treasury bonds to choke on, as the government tries to finance this debt.

In the three months to Sept. 30, the Treasury Department borrowed $530 billion; in the first quarter of the New Year – which ends March 31 – it expects to borrow $368 billion. The March figure looks thoroughly optimistic; the monthly Treasury Statement of Receipts and Outlays shows that the first calendar quarter of the year is generally about $80 billion to $100 billion worse than the preceding fourth quarter. Thus a borrowing figure as low as $368 billion would seem to include no bailout costs and no additional recessionary costs from the current quarter.

If I had to guess, I’d assume borrowing would be about $500 billion in the first quarter, even if the U.S. banking system manages to say upright for the entire quarter – something that’s by no means certain.

Interestingly, Goldman Sachs Group Inc. (NYSE:GS) appears to agree with this. Goldman –formerly the country’s largest investment banker – said last week that in the year to September 2009 the Treasury would have to borrow about $2 trillion. That would suggest a rate of about $500 billion per quarter. That figure, too, is based on a belief that the recession remains fairly shallow, and that the new administration doesn’t have to add any major new stimulus programs – both pretty optimistic assumptions.

Goldman estimates that the Treasury Department will resurrect its three-year T-note issues, will speed up the issuance of two-year notes and 10-year bonds, and will “reopen” past Treasury issues that are now “off the run” (i.e. have maturities that aren’t a round number of years), thus adding to the supply of nine-year Treasuries, for example.

While the gross issuance of Treasury securities has to be netted against redemptions to calculate the net increase in Treasury borrowing, $2 trillion is a lot, and net of redemptions represents about $1.4 trillion in new money. That is unlikely to come from foreign central banks, the principal source of Treasury funding in the last few years. Net foreign purchases of U.S. securities in the 12 months to August 2008 totaled $543 billion, and it was about the same in the previous year. That means $800 billion to $900 billion of new money for Treasury purchases has to come from domestic sources.

Inevitably $800 billion to $900 billion of additional money flowing from domestic investors into Treasury bonds will do three things:

• It will drive up interest rates on Treasury bonds.
• It will tend to “crowd out” other financings, making finance difficult to obtain for medium-sized and smaller companies and more expensive even for the behemoths.
• And finally, it will increase inflation, as the Fed is forced to expand money supply to give investors enough money to buy all the Treasuries.

That suggests one overpowering conclusion: Don’t eat the food that Uncle Sam is trying to stuff you with in such vast quantities, except the short-term maturities if you are very hungry (have cash burning a hole in your bank account). If Treasury yields are going up, prices will drop, particularly at the long end of the maturity spectrum.  Furthermore, rising inflation makes fixed-interest-rate bonds a poor bet.

If you’re really dying to own paper issued by the U.S. government, you should look at Treasury Inflation Proofed Securities (TIPS) on which interest and principal are indexed to the U.S. Consumer Price Index (CPI). These were a lousy deal earlier in the year, but yields have since risen. Now, you can get a yield higher than 3%, plus inflation protection on 10-year or 30-year TIPS. Indeed, at the 10-year maturity, TIPS yield 3.04%, whereas regular Treasuries yield 3.90%, indicating that the market thinks inflation will average only 0.86% annually over the next decade.

If the market thinks that, it’s nuts. If inflation averages 7.3% over the next decade, as it did in the 1970s, a TIPS purchase will yield about 10.3% in nominal terms, about as good as you will find anywhere and far above conventional Treasury yields.

Thus, inflation-linked Treasuries are currently a much better bet than conventional Treasuries, and well worth taking a look at. You might also consider the Rydex Inverse Gov Long Bond Strategy Fund (RYJUX), which invests in a portfolio of short positions in Treasury bond futures and will therefore rise in value as T-bond prices decline.

The U.S. Treasury may want you to gorge on its offerings, but in this case a strict diet is the best policy.

Source: The Treasury Department is Choking on Debt, But You Don’t Have To

Martin Hutchinson says the Fed has finally starting doing its job: putting price stability over Wall Street’s demands. Real interest rates are negative. This is feeding inflation. It also means Treasury bond yields – also currently below the rate of inflation – are too low and should begin to rise again.

Martin says investors can profit from this situation with the Rydex Juno Inverse Government Long Bond Strategy (MUTF:RYJUX).

More from Martin in Money Morning:

The statement that was issued after the policymaking meeting was somewhat “hawkish,” suggesting that the U.S. Federal Reserve is awakening to the dangers of persistent and gently rising inflation.

Wall Street was initially spooked: it had hoped for the usual bounce that follows a Fed rate cut. However, investors subsequently decided the Fed’s inaction meant things weren’t so bad after all. Actually, the inaction was the first example in several years of the Fed doing its job – standing up to the easy-money politicians and Wall Street in the pursuit of lower inflation.

The Consumer Price Index (CPI) for August registered a decline in prices of 0.1%, which observers hailed as an indication that inflation worries are at an end. But don’t you believe a word of it; the decline was entirely due to the recent fall in oil prices, which we here at Money Morning expect will one day reverse course and resume their upward march. The only question is when that will happen and what the catalyst will be to make it so.

In terms of the CPI, the “real” consumer price inflation was actually 5.4% over the past 12 months, which makes the 2.0% Federal Funds rate look pretty silly.

The same is true all over the world: Inflation rates are either well above the local bank base rates (2.3% vs. 0.5% in Japan, 12.1% vs. 9.0% in India), or are only just below them (3.8% vs. 4.25% in the Eurozone, 4.8% vs. 5.0% in Britain). Only China has inflation of 4.8% to go against a bank rate of 7.2% – just reduced from 7.47% – but China had been holding prices down with direct controls for the Summer Olympic Games, so its current inflation number is pretty dodgy.

If interest rates are at or below the inflation rate in most of the world, then it follows that global monetary policy is expansionary and inflation can be expected to increase generally.

You can’t entirely blame the world’s central banks; we have been in a credit crunch for more than a year now, and investment banks the size of Lehman Brothers (NYSE:LEH) and Merrill Lynch (NYSE:MER) getting in trouble is a pretty good indication that all is not well. However, there’s also no denying that low or negative real interest rates will tend to produce an acceleration of inflation.

The two objectives – saving the world banking system, and keeping inflation under control – are in conflict.

The market demonstrates the solution to the conflict.

On Monday the Federal Funds rate traded for much of the day at 6.0%, versus the Fed’s target of 2.0%. To get the market Federal Funds rate down towards the target, the Fed needed to inject lots of liquidity, which it did – to the tune of about $70 billion.

That liquidity increased the money supply, but only to make up for the decrease caused by bank failures and market fear, thus restoring the market’s balance and lowering the Federal Funds rate to about 3.0% by the end of the day’s trading. An interest rate cut Tuesday would simply have moved the “target” Federal Funds rate, rather than the actual rate, and would have led to more inflationary pressures without materially helping the banking system.

Indeed, one can wish that the Fed had confined itself to injecting liquidity throughout this prolonged credit crunch, keeping the Federal Funds rate level at its September 2007 level of 5.25%. In that case oil prices would probably never have soared to $147 a barrel, and U.S. inflation might have remained safely around 3.0%.

Going forward, it seems clear that next time the FOMC meets without having had about half of Wall Street disappear in the preceding week (the next scheduled meeting is Oct. 28-29), it will be tempted to announce a modest interest-rate rise, unless the U.S. economy is truly in the tank by then. Of course, the Fed would remain ready to lower rates again if a deep recession appeared, or to inject liquidity if more banks got in trouble.

That would suggest that the current sharp drop in yields on long Treasury bonds has been overdone (from 4.25% in June to 3.25% yesterday (Tuesday) morning, before rebounding to 3.49% at yesterday’s close). Thus, a rebound in Treasury bond yield – taking them significantly above the level of inflation – is called for as money is tightened and the Federal Funds rate rises.

To take advantage of such a yield rebound, you should consider the Rydex Juno Inverse Government Long Bond Strategy (MUTF:RYJUX). This invests in short futures contracts on long-term Treasuries. It can be expected to gain as Treasury yields rise.

Source: Federal Reserve Policymakers Stand Up to Wall Street’s Easy-Money Crowd

We already know the budget deficit is going to return to the $400 billion level – actually $410 billion – in Fiscal 2008, which ends in September. But what is only just now becoming clear is that the $410 billion figure is likely to mark a trough, not a peak, and that a budget deficit of $1 trillion is likely as early as Fiscal 2009 or Fiscal 2010.

The main reason for the probable swing in the deficit is the current period of slow growth and the impending recession.

For example, 2001-02 was a recession but a pretty wimpy one that lasted from March to November 2001. In August 2001 – well into the recession, and after the 2002 budget had been thoroughly debated – the mid-session budget review projected that 2002’s budget would show a surplus of $173 billion. In reality, only 14 months later, the final figure for 2002 showed a deficit of $304 billion, a swing of $477 billion, or 4.5% of gross domestic product (GDP). Add 4.5% of a $15 trillion GDP to Fiscal 2009’s projected $407 billion deficit and you get a deficit of $1.082 trillion. Thus a trillion-dollar deficit is certainly possible without even assuming an administration or Congress go mad, or a re-run of the Great Depression.

The main factor that has made this year’s budget deficit outcome relatively benign, in spite of the $150 billion in tax rebates, is the huge revenue boost from bonuses and capital gains, most of which are received in April. In April 2008, revenue was $404 billion, 16.0% of expected total revenue for the year. That was a new record, not only in amount (which you might expect), but also as a share of the year’s total revenue – the previous record was April 2001, when revenue was 15.5% of the total for the year.

Note that 2007’s stock market gains and Wall Street bonuses were bigger relative to the U.S. economy than those of 2000, the previous record holder, and also that there is a lag between the market turning down (and bonuses beginning to diminish) and tax revenues falling off. The stock market peaked in March 2000, yet it was in 2002-04, not in 2001, that we saw a sharp drop-off in April’s revues as a share of the year’s total. Thus, it is in 2009 and 2010 that we can expect to see a similar drop-off this time around (and probably one that’s somewhat steeper, because April 2008’s record revenue figure was more extreme).

A Budget Deficit Burdened by Billions in Bailouts

In 2001 and 2002, the new Bush administration cut taxes by about $150 billion per annum, and also increased spending (though not for the Iraq War, which began after Fiscal 2002 ended.) It’s pretty unlikely that we will see a similar tax cut in Fiscal 2009 or 2010 (though a short-term stimulus similar to the recent one might be possible).

However, over and above the normal increases in federal spending we will have an additional factor: The cost to the taxpayer of bailing out Fannie Mae (FNM), Freddie Mac (FRE), Bear Stearns Cos. Inc. (BSC) and possibly even the Deposit Insurance Fund itself, should any more banks the size of IndyMac Bancorp Inc. (OTC: IDMC) go bust and require payouts.

The Congressional Budget Office (CBO) recently estimated the bailout cost for Fannie Mae and Freddie Mac at a total of $25 billion. Don’t believe a word of it! Both political parties seem to want to bail these mortgage giants out, so the CBO appears to be deliberately low-balling the estimate in order to make the bailout go through smoothly.

First, they assume a 50% chance that bailout funds will not be needed (thus reducing the “expected value” of the payout from $50 billion to $25 billion. In reality, while there certainly is a chance that bailout funds might not be needed, it’s nothing like 50%. Fannie Mae and Freddie Mac loaded up their books with subprime mortgages in 2005-2007, and would be insolvent today if they had been forced to account for those assets on the same basis as the Wall Street banks. Thus, the chance that their losses on the rubbish paper they hold will exceed their capital is far more than 50%.

At the other end of the risk spectrum, the CBO admits (deep, deep, in the undergrowth of impenetrable bureaucratic prose, and not included in the summary) that there is a “5% chance” that the bailout will cost more than $100 billion. Market analysts not on the government’s payroll seem to agree that $100 billion to $150 billion is a conservative estimate of the bailout’s cost, with one analyst putting its potential cost as high as $600 billion.

Add to the probable $100 billion to $150 billion cost for rescuing Fannie and Freddie the $300 billion Congressional Budget Office estimate of the cost of currently impending housing bailout legislation, and you will see that even without any expansive 2009 plans of a President John McCain or President Barack Obama, there are plenty of deficit-busting items coming down the pike, which will easily match the cost of 2001 Bush tax cuts. The eventual rise in interest rates to battle inflation will also increase the U.S. Treasury’s funding costs, further increasing deficits.

Therefore, all we need to get the $1 trillion deficit in either Fiscal 2009 or 2010 is a genuine recession, at least as large as the 2001 downturn. Optimists may disagree, but I would rate the chance of such a recession as being pretty high, and indeed would expect a recession rather deeper than the wimpy 2001 affair, perhaps matching the more serious recessions of 1990-91 or even 1981-82.

Positioning for Profit Despite the Budget Deficit

If you think such a recession is likely, you need to invest accordingly. Stocks are no good, because earnings will continue to be battered, so the stock market is unlikely to zoom up. However, the real losers from a trillion-dollar deficit will be U.S. Treasuries, which will no longer appear a safe haven to even the doziest Asian central banks, and so will have to rise in yield to compensate both for the increased funding needs caused by the deficit and the increased inflation we are now experiencing.

There are two approaches to investing for a trillion dollar deficit:

• First, you can avoid the U.S. junk bond market altogether, and buy foreign bonds denominated in currencies other than dollars. An attractive vehicle for this is the T. Rowe Price International Bond Fund (RPIBX), which has yielded 5.65% to U.S. investors so far in 2008.

• Second, you can buy a fund that shorts Treasury bond futures, profiting from rises in yields. The best known such fund is the Rydex Inverse Government Long Bond Strategy Fund (RYJUX), which increases in price as long-term government bonds decline.

Source: Prepare to Profit from the Trillion Dollar U.S. Budget Deficit