David Einhorn
It's the ultimate doomsday trade: betting against U.S. Treasuries, based on the view that the United States will eventually go the way of countries like Greece.
The idea of the United States facing serious solvency worries may seem far-fetched as nearly everyone considers Treasuries to be the world's leading safe-haven investment.
But there are people out there who think Treasuries, the formal name for U.S. government debt, don't deserve their status as the ultimate risk-free investment. A small number of investors are wagering on a deterioration in the financial position of the U.S., and the dollar, to the point that the country experiences debt jitters or runs the printing presses to inflate its debt problems away. If the worries become a reality, Treasuries, now flying high, would plunge.
The most high-profile investor betting against Treasuries for these kinds of reasons is David Einhorn, president of hedge fund Greenlight Capital, best known as the prescient money manager who blew the whistle on the problems at Lehman Brothers months before the investment bank collapsed in September, 2008.
Mr. Einhorn, who declined to be interviewed, has said in speeches at investment conferences that he's worried about the finances of the U.S. and has been buying long dated, out of the money options designed to pay off if interest rates on U.S. government debt surge. He's made the same rate wager on Japan, which is even more indebted than the U.S.
To make the trade, Mr. Einhorn used options, rather than the conventional strategy of betting on rising interest rates by shorting bonds, to limit his losses if he's wrong, while still having a lot of leverage if he's right and there is an upward spiral in rates.
One of the reasons he structured the trade this way was that if the economy dips into recession, it would cause a rally in Treasuries (whose prices moves in the opposite direction to interest rates), causing large losses for short sellers. Mr. Einhorn's at-risk money is limited to the options price.
"This is absolutely a speculative thing, which may or may not turn out to be a worthwhile trade, but it's what the hedge funds are doing," says Marti Subrahmanyam, a finance professor at New York University.
Mr. Subrahmanyam said the options Mr. Einhorn purchased are likely over-the-counter instruments produced by an investment bank, and therefore not available to retail investors. A typical option might run four or five years and begin to pay off if U.S. 10-year Treasury rates, currently around 2.9 per cent, surge above 5 per cent.
Depending on how high rates go and the structure of such an option, a gain of many times the investment "is conceivable" on such trades, Mr. Subrahmanyam said. However, if rates don't reach the option's strike price before expiry, the security ends up worthless.
Although it is hard for retail investors to duplicate the option trade, leveraged bets on higher interest rates are available through long dated Eurodollar futures contracts, which trade in the U.S. and have reasonably liquidity out to terms of five or six years, he said. Market-traded rate options typically have terms of only about a year.
Currently, many investor are worrying about a weak economy leading to deflation, or a general fall in price levels, which would enhance the value of Treasuries and cause rates to fall rather than rise.
"As long as deflation is out there, the inflation or hyperinflationary scenario just doesn't play," says Martin Braun, president of Adaly Investment Management Corp., a Toronto money manager.
Any bet on higher interest rates might take a long time to pay off. "I'm not sure that this trade will come home within one year," commented Mr. Braun.
Some savvy investors are buying Treasuries now, based on a view that the U.S. isn't facing economic Armageddon, but is mired in a long-term period of financial de-leveraging, or the paying down of debt. This will keep economic growth anemic and inflation benign, a good environment for Treasuries.
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Hoisington Investment Management Co., a Texas money manager, has been betting on lower rates for this reason, and its president, Van Hoisington, doesn't believe the U.S. could get an inflationary spiral going, even if the Federal Reserve Board resumed its program of quantitative easing through the buying of more Treasury bonds.
Fed buying of the bonds creates worries the government is printing money and risking inflation.
Mr. Hoisington said that if the Fed buys bonds, the money would stay stuck in the banking system's reserves, and not trigger renewed inflation. "Right now, thus far, what we have is the inability to create deposits or money. We have debt being repaid at record rates," he said.
In order to cause inflation, monetary authorities would have to do something really unconventional, such as issue newly created money directly to the public, he said.
Mr. Einhorn has said he hopes he's wrong about the U.S. facing a solvency crisis, but besides betting on U.S. government interest rates going up, he's doing another trade to prosper if the U.S. tanks: buying gold stocks.