The Single Best Trade for 2010

What was the single, most damaging trade of 2009? There are a number of candidates: short stocks, short gold and long the dollar would all be in the running. These would have all been painful trades, but not nearly as painful as shorting Eurodollars - i.e. betting that short- term interest rates would RISE.

Furthermore, this losing trade would also have been the most baffling. Throughout the year, it seemed as if the pieces were falling into place for a big spike in short-term interest rates. The Fed was printing money like there was no tomorrow; the dollar was tanking, which raised fears that the Chinese would dump US debt; and gold - that well-known inflation barometer - kept powering higher.

A jump in short interest rates seemed like an easy bet. It was almost a no-brainer. Except that it wasn't...We suspect a lot of smart investors got hurt on this trade. What they did not count on was the possibility that fear and risk-aversion would cause investors to herd into short- term instruments like T-bills...and that investors would continue herding into these instruments even after rates fell dramatically.

With the benefit of 20/20 hindsight, it is easy to see why short-term interest rates plummeted this year. After the economic collapse of 2008, the Fed had one goal and one goal only - to recapitalize the banking system. TARP was just the first step. The only way to achieve banking health after the terrible implosion of the real estate market was to "guarantee" profits for the major banks. The Fed pursued this objective by extending massive amounts of credit to the banking system at interest rates near zero, thereby enabling banks to replace high- cost financing and capture a healthy spread on their loan books.

This gimmick has worked well...too well.

Big money-center banks are borrowing money from the Fed's discount window at 1/4 percent and then turning around and buying 10-year Treasurys yielding 3.2%. This represents a "risk-free" profit of just below 3% in an environment that is still more deflationary than inflationary. Of course, if long-term rates run were to run higher, these plump interest rate spreads would turn negative and produce losses. But that's a problem for another day.

As long as short-term interest rates remain at rock-bottom levels, banks will continue to buy T-bonds and other higher-yielding instruments. In other words, the Fed is subsidizing the purchase of Treasury notes and bonds, which is helping to keep long-term rates low. (The Fed may tell the public that it is keeping rates low to encourage bank lending, but in so doing the Fed is actually DIS-couraging it. Why lend to small business when you can make a guaranteed 2.9% return lending to the government?)

But this game won't last forever. We doubt the Fed will be able to maintain low short-term interest rates indefinitely. Market forces may force the Fed's hand as early as next year. As inflationary pressures build and/or the dollar continue to weaken, the Fed will be forced, if not to raise rates directly, then to tweak its policy statement so that expectations of continuous, rock-bottom rates are disrupted. Either event could have far-reaching consequences for all of the markets...especially the Eurodollar market that tracks short-term interest rates.

We expect the Fed will hike short-term interest rates if the bull market in gold and/or the bear market in the dollar get out of control. Or should we say, MORE out of control.

Rather than wait for this event to occur, we are advising our clients to position for it now by buying long-dated put option spreads on Eurodollar futures. We prefer options that expire in 2011 so that there is plenty of time for the trade to work.

Obviously, there is no guarantee that short-term rates will rise soon from today's extremely low levels, but we like the odds.

Regards,

Steve Belmont
for The Daily Reckoning Australia

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