Don't Like Tax Deal? Bet Against It

12/20/2010 3:21 pm EST

Focus: ETFS

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

An ETF that’s poised to rise with long-term rates is getting help from the budget-busting tax compromise, writes Doug Fabian, editor of Successful Investing and Making Money Alert.  

The big talk in Washington and on Wall Street is the extension of the Bush tax cuts.

Here's a quick rundown of the terms of the tax deal worked out by President Obama and Republican leaders in Congress:

  • A temporary, two-year extension of the Bush tax cuts for all income levels, including for those families that make more than $250,000 per year
  • An extension of the 15% tax rates for long-term capital gains and qualified dividends
  • A resumption of the estate tax to a rate of 35%, including an exclusion on the first $5 million per person. The estate tax was set to rise to a rate of 55% with an exclusion only on the first $1 million
  • A one-year, two percentage-point reduction in Social Security withholding taxes (FICA)
  • A 13-month extension of emergency unemployment benefits

[And don’t forget another reprieve from the ravages of the alternative minimum tax, repeals of limits on itemized deductions and of the phaseout for personal exemptions, as well as an extension of the child credit, the child-care credit, and the tuition deduction—Editor.] 

There's been a lot of criticism from the extreme wings of both parties, with liberal Democrats saying the president sold out on the issue of making the rich pay more. Those on the right think that the temporary nature of the tax cuts, as well as the increase in unemployment benefits, will hamper future decision-making and will cause even bigger deficits in the coming year (count me in with this group.)

Deficit Sticker Shock
Certainly, the argument about a bigger deficit next year has been confirmed by the bond market. Long-term Treasury bond yields surged right after the agreement was announced. Why? Well, the deal is going to add $858 billion to the federal deficit. That increased deficit is bad for both Treasury bonds and municipal bonds and, hence, the spike in bond yields.

Just take a look at the one-month chart of the 30-Year T-Bond Yield ($TYX). As you can see, yields spiked immediately following the president's Dec. 6 announcement of the tax deal.

The prospect of bigger and bigger budget deficits should be nothing new. For months now, we've been warning about the tremendous amount of borrowing that's going to be needed by sovereign governments around the world—including the United States—just to stay afloat in 2011. Some estimates peg that number at an incredible $10.2 trillion.

Those are debt levels not seen since World War II.

This tax deal isn't going to help that deficit at all, and bond traders know it. According to economists at J.P. Morgan, there likely will be a $1.5 trillion shortfall for the current fiscal year, up from their previous $1.2 trillion forecast. For fiscal 2012, their projection is up to $1.2 trillion, from $1.1 trillion, as the two-point cut in payroll taxes gets reversed.

What all this means is that the Treasury is going to have to sell more securities to fund those larger deficits, and that means bond yields (i.e., long-term interest rates) will continue to rise.

ETF Profits From Bonds’ Pain 
Fortunately, we have exposure to an exchange traded fund designed to go higher along with bond yields. The ProShares Short 20+ Year Treasury (NYSEArca: TBF) is an ETF designed to deliver performance equal to the inverse of the 20+ Year Treasury Bond Index. This fund recently surged above its 50-day moving average. [It’s also poked above the 200-day before pulling back toward that line over the last two days—Editor.]

The jump is a clear sign that the smart money thinks yields are way too low.

To protect ourselves on the downside if things don’t go our way in TBF, we recommend that you place a stop-loss order at $40 along with your buy order. [Friday’s closing price was $44.69—Editor.]

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