Why Bill Ackman Is Shorting 30-Year Treasuries

In 2020, Bill Ackman shorted the credit market to the tune of $27 million – and it earned him $2.6 billion. Now, he’s at it again: the founder and CEO of Pershing Square Capital Management is making a hefty bet against 30-year US Treasuries as both a hedge against the impact of higher long-term interest rates on stocks and as a high-probability standalone play. If you’re thinking you wouldn’t mind riding this legendary investor’s coattails, here’s how you can replicate his latest big trade.

Why bet against Treasuries?

1) The US government’s budget deficit is ballooning.

Tax cuts, new stimulus measures, higher defense costs, and increased spending on government programs, combined with several economic upheavals, have inflated the government's budget deficit – that is, the gap between its outgoings and its revenue. That shortfall is expected to hit $1.4 trillion for the first nine months of the current fiscal year – an increase of approximately 170% compared to the same time last year. To plug that gap, the US Treasury Department is forced to sell more bonds. For example, it recently boosted its net borrowing estimate for the current quarter to $1 trillion – a serious leap from the $733 billion it predicted in early May.

But here’s the bigger problem: increased bond issuance only exacerbates the US's already swelling debt pile at a time when interest rates are a lot higher, leading to steeper interest payments and a further widening of the budget deficit. That leads to a vicious cycle of even more bond sales, with even higher interest due and so on. As you’d expect, all that issuance puts downward pressure on bond prices. And in the meantime, the Federal Reserve continues to “roll off” its Treasury holdings (not buying new bonds when the ones it owns mature) to the tune of up to $60 billion a month, and that means the Treasury Department has to find other buyers.

The US government's spending on interest payments has surged because of rising rates and the country's rapidly swelling debt pile. Source: Bloomberg.

2) Two (of three) big rating agencies no longer consider US debt to be top-tier.

Fitch Ratings’ decision last week to downgrade US government debt one notch, from AAA to AA+, highlighted the booming deficits that are at the heart of the bear case for Treasuries. For example, the agency said that it expects the budget deficit to rise to 6.3% of the size of the US’s economy this year – up from 3.7% in 2022. Surely that’s got some investors worrying. What’s more, Fitch is forecasting that the US’s debt pile will reach 118% of the size of the country's economy by 2025 – over three times higher than AAA-rated countries’ median of 39%.

Lower credit ratings typically increase a country’s borrowing costs in debt markets. However, it’s not clear whether that’ll happen in this instance. S&P Global Ratings took away the US’s AAA rating in 2011, after all, and there was little (if any) long-term effect on the country’s borrowing costs. But Fitch’s downgrade could dampen investors’ appetite for the world’s biggest bond market. It could also force some funds to shed their Treasury holdings if their mandate allows them to invest only in bonds rated AAA by at least two of the three main agencies.

3) Japanese investors are dumping Treasuries.

Japanese investors are the biggest non-US holders of Treasuries. And they pulled a record $181 billion out of foreign bonds last year (two-thirds of them from US Treasuries), and poured $231 billion into local government bonds. You can see why in the chart below: the pink line shows the yield on 10-year Japanese government bonds (i.e. what Japanese investors can earn at home) and the blue line shows the currency-hedged yield on 10-year US Treasuries (i.e. what they can earn in the US without worrying about fluctuations in the dollar-yen exchange rate). And since mid-2022, Japanese investors have been able to earn more at home.

US Treasuries are a losing proposition for Japanese investors. Source: FT.

These flows could accelerate even more. Those Japanese bonds got even better looking last month, when the Bank of Japan signaled it would allow 10-year yields to go as high as 1%, instead of the previous 0.5%. This matters (a lot) because there’s still more than $1 trillion worth of Treasuries held by Japanese investors left to potentially be dumped.

4) Higher long-term inflation could push 30-year Treasury yields higher.

Ackman figures there are some major structural changes that are likely to lead to higher levels of long-term inflation in the US, including deglobalization, US-China economic decoupling, and the greater bargaining power of workers. With all those factors, he says he’d be “very surprised” if we don’t end up with persistent long-term inflation of around 3%. If that happens and history holds, his back-of-the-envelope math looks like this: 0.5 percentage points (the real interest rate) + 3 percentage points (inflation premium) + 2 percentage points (term premium, i.e. extra reward for holding long-term debt) for a 30-year Treasury yield of 5.5%. That's notably above the current 4.2% yield, and would lead to a roughly 19% drop in the bonds’ prices.

5) Lately, Treasuries haven’t been working as an effective stock hedge.

As a stock hedge, Treasuries have been putting in their worst performance since the 1990s. Traditionally, Treasuries would rally when stocks tumble, serving as a hedge and contributing to the success of the 60/40 portfolio strategy (with 60% held in stocks and 40% in bonds). However, the one-month correlation between the Bloomberg US Treasury Total Return Index and the S&P 500 rose to 0.82 last week, indicating that bonds and stocks are moving almost in lockstep.

Bonds and stocks haven't been this tightly correlated since 1996. Source: Bloomberg.

Between 2000 and 2021, the correlation between the two asset classes averaged -0.3. But that all started to change last year when the US central bank started to raise interest rates to combat inflation, impacting both bond and stock markets. This all matters because if Treasuries lose their appeal as a portfolio diversifier, then investors could start to shun them – especially in light of all the other factors discussed above.

What’s the opportunity here?

To bet against long-term Treasuries, you could simply short the iShares 20+ Year Treasury Bond ETF (ticker: TLT; expense ratio: 0.15%). However, Ackman is making his bet via options, rather than shorting bonds outright. So to better replicate his trade, you could buy “put” options on TLT instead. But this is a more involved trade and requires you to select a specific option contract with a set expiration date and strike price (that is, the price at which you can sell the underlying asset).

There have been times when the bond market has repriced the long end of the yield curve in a mere matter of weeks, and Ackman says the situation today seems like one of those times. Put differently, he reckons that 30-year Treasury yields could jump higher toward his 5.5% estimate in relatively short order. If you like his record, and you think he’s right this time around, you could consider buying cheap, out-of-the-money put options expiring in December (for example). TLT is currently trading at $95.50, and a put option on the ETF with a strike price of $90 expiring on December 15th goes for around $1.30. So this option would be profitable if TLT dips below $90, minus the $1.30 (the cost of buying the put) = $88.70. That’s a roughly 7% drop in TLT’s price. But if you recall, Ackman reckons the drop could be closer to 19% should 30-year Treasury yields hit 5.5%.

What are the risks?

First, being short Treasuries is starting to look like a crowded trade among hedge funds. Should that sentiment turn, prices could spike as many funds rush to hit the exits at once. Second, with a dividend yield of over 3%, you stand to lose that much every year shorting TLT even if its price remains unchanged (a high dividend yield also impacts put options by increasing their cost). And third, Treasuries could stage a major comeback if the US economy does enter a recession, as many expect. In fact, according to a recent investor survey by Bloomberg, roughly two-thirds of the 410 respondents anticipate a downturn in the world’s biggest economy by the end of 2024. And as a result, almost 60% of the respondents say now is a good time to buy Treasuries with maturities longer than seven years.