A BEAR MARKET IN GOVERNMENT Erin Arvedlund Earlier this month, we spoke with investors who are avoiding long-term

U.S. Treasury bonds. Now weve come across one fund manager whos actually shorting Treasuries or betting they will fall in price and taking advantage of what he terms is the coming bear market in government. Michael Aronstein is president and portfolio manager of the Marketfield Fund (MFADX), a $4.4 billion mutual fund that has returned just over 13% last year and 8% annually since inception in 2008. Aronstein wants investors to realize governments havent cut their debt the way the rest of American households have. And government bond issuers with impaired balance sheets and the weakest underlying fundamentals have fallen first. Greece, Detroit, Egypt and other government creditors are harbingers of a more widespread problem in the U.S. sovereign debt, Aronstein writes in his latest client letter, available here [imbed link to PDF]. As a result, his Marketfield Fund has established meaningful short positions in long duration government bonds during the past six months in response to this risk. No one knows exactly when, but credit demand in the private sector will begin to crowd out government borrowing and prompt a rise in interest rates, he believes. Marketfield CEO Shaoul, in an interview, says any retail investor can copy this trade of shorting Treasury bonds, or betting the price will go down. The most popular route is via an exchange-traded fund called iShares Barclays 20+ Year Treasury Bond Fund (TLT); by shorting the fund, investors can take the position in their portfolio that U.S. long-term Treasuries will drop in value. There are some more aggressive and much riskier ETFs such as ProShares UltraShort 20+ Year Treasury (TBT), which uses borrowed money to double up on the same bet. The fund seeks investment results that correspond to twice (200%) the inverse, or opposite, return of the daily performance of the Barclays Capital US Treasury 20+ Year Treasury Bond Index. We started shorting Treasuries in mid 2012, and its been comfortable short. It hasnt put us under any pressure, Shaoul says. The U.S. business climate is improving, and therefore the biggest risk for Treasury holders is things going right [with the economy], not wrong. Investors would likely then flee Treasuries, pushing the bond prices down. Global economic data could very well surprise to the upside, the bond market misbehaves and overwhelms the Federal Reserve. The fact that they are targeting inflation and unemployment is very peculiar, and they have been wrong since 2009, says Shaoul.

Sophisticated investors can also buy put options on Treasuries also wagers that the prices will go down. From a timing perspective, the danger point for credit markets could be close at hand. Housing activity continues to accelerate, business investment is turning up, the U.S. government is resisting expenditure cuts and the Federal Reserve is continuing with policies that seem appropriate for the summer of 1932, Aronstein contends. The only mechanism that might change cavalier attitudes toward spending is the bond market. If government remains on its current heading, fiscal discipline is going to be imposed rather than chosen. When we reach that stage, the volatility now associated with equities may migrate to fixed income markets. Like teenagers running into the basement at the beginning of a horror movie, investors who have looked to government bonds as a refuge from market risk may be in for some surprises. Marketfield Fund holds plenty of equities as well. Its top holdings as of December 31, 2012, included BASF of Germany, iShares Dow Jones Transport Average ETF, SPDR S&P Regional Banking ETF, iShares MSCI Mexico, Eagle Materials, USG Corp., CRH PLC, iShares MSCI Italy Index ETF, Wolseley PLC and General Electric. But again, he sees an opportunity to short the U.S. Treasury market, and Treasury ETFs may be a way to profit. --enditall Contact Erin Arvedlund at 646-797-0759 or erinarvedlund@yahoo.com. Previous columns are at philly.com/arvedlund.