FXY Invesco CurrencyShares Japanese Yen Trust

Besides riding the US equity market bull train higher this year, there is a triplet of trades I've had some success with as interest rates rise. I am back in all three of these trades.

The following is my rationale and a chart for each. And they are also listed in order of conviction.

1) Short US Treasury Bonds via the ProShares UltraShort 20+ Year Treasury ETF (TBT)

This is my best and easiest way to play the "normalization" of interest rates as the Fed plans to phase out of the bond-buying business eventually. Just ask yourself, what's normal about the US 10-year yield at 2.5% when the economy is growing at 1.5% and inflation is over 1%?

Maybe that is acceptable in a distorted and artificial QE world. But growth and inflation should only accelerate from here, albeit slowly. And this should force the 10-year to yield closer to 3% if not 3.5% in the next 6-12 months.

Regardless of big theories about a "great rotation" out of bonds and into equities by both individuals and conservative bond-loving pension funds, we are beginning to see the signs of a "small rotation" as money leaves bond funds and enters equity funds in the past few months.

This trickle will only accelerate as investors realize they will never regain that principal and stand to lose more.

In Market Timer, we've traded TBT swings five times since September 2012 and all were profitable. We are long again and looking for the 10-year to move above 3% before it hits 2%.

Risks to this trade: The Fed leans toward a "later taper" of QE3 bond-buying -- say Q1 of 2014 -- and/or the stock market enters a hard correction both of which could cause bonds to rally and the 10-year to go back toward 2%.

I believe the risk from our average entry point in TBT at $75.83 (16.82% cash position*) is under 10%, while the potential reward is north of 20%. My conviction in this trade is very high because I don't see US long rates going back under 2% in any likely scenarios.

2) Short Gold via the DB Gold Double Short ETN (DZZ)

As interest rates rise, even while disinflation persists, gold has no where to hide. It offers no static return and is therefore worse than cash in many respects because you are charged for storage and insurance directly or indirectly. And these costs only go up in a higher interest rate environment.

Sure, if you caught the bull trend in the last decade, you more than covered the 0.4% annual expense ratio of GLD (probably the cheapest charge for owning physical gold indirectly you will find anywhere). But how many investors could stay in that bubble, or trade in and out of it, for ten years vs the thousands of stocks to choose from in the US equity markets?

My soundbite question to people is this question: What would you rather hold... an ounce of a shiny yellow metal that pays you nothing despite its rich mythology, or $1300 you can use to invest in equities, high-grade corporate bonds, or real estate?

Yes, gold is "supposed to" continue trending higher because of Federal Reserve money printing, which devalues the US dollar and makes gold a "safe haven" and "store of value."

I just think these cliches are worn out now. The dollar and US equity markets have proven their worth to the entire world recently. And while there is still risk that our currency could depreciate against the euro, the pound, the yen, or a dozen other markets we trade with and like to vacation in, the fact is that there are many other better ways of beating natural inflation.

Risks to this trade: Central bank appetite for gold resumes and/or fall seasonal buying from India and China ramps up in August and September.

I believe the risk from our average entry point in DZZ at $6.85 (5.92% cash position*) is under 15%, while the potential reward is about the same allowing for a lot of back in forth in a big range for gold between $1400 and $1200 in the next 3-6 months before new lows are made below $1180. This 1-to-1 risk-reward ratio could entice me to trade in-and-out around a core short position.

In Market Timer, we made nearly 35% in DZZ from late April to late June as gold fell from $1475 to $1225, a 17% decline.

3) Short Japanese Yen vs US Dollar via the ProShares UltraShort Yen ETF (YCS)

With the giant Bank of Japan stimulus operations launched this year, their Nikkei stock index soared 40% in the first half of the year. These central bank liquidity actions were also designed to weaken their currency and that plan worked too, sending the USD/JPY exchange rate surging from 87 to 103, a move of over 18% which is pretty steep in FX in only 5 months.

The Japanese want a weaker yen and they are willing to do almost whatever it takes in terms of monetary policy to make that happen. We didn't catch the first big move up earlier this year, but we did buy the drop back to 94 and ride that bounce to 100 USD/JPY.

In YCS that meant buying the ETF at $59 and taking profits above $65. We just re-entered the trade near $63 because it appeared like USD/JPY was finding support near 98 and I am looking for a continued move above the recent highs of 103.

But there is risk that USD/JPY could go all the way back down and test 94 or lower before making its longer term expected move to the 105-110 region.

So in this trade we have the least edge and therefore I have the least conviction of the three higher interest rates-higher US dollar trades. The equivalent of USD/JPY going to 92-94 would be YCS going to $55-57.

I believe the risk from our entry point at $63.25 (6.8% cash position*) is under 15%, while the potential reward is over 20%. Since this position is large for a volatile currency pair in which I have the least conviction, my stop will be flexible based on changing conditions.

*A few words are in order about position sizes with leveraged ETFs. All positions above are noted as a percentage of total portfolio value. "Cash" simply means that I am not acknowledging the true leverage and "speed" with which these positions could move in (or against) my favor.

For a more conservative view of using double-leveraged ETFs (as all 3 of the above are), one could multiply the position size by 2. This should be considered a mandatory practice when using leveraged equity ETFs, where total combined positions can give you net long (or short) equity exposure that is greater than 100%.

Balancing Risk & Reward When Taking on Bigger, Smarter Money

Obviously in this short article, I have not given an in-depth technical view of each trade rationale. To me, these are all techno-fundamental trades that I see an edge in to one degree (TBT = strong conviction) or another (YCS = lesser conviction).

I could be very wrong about these closely-correlated one-way trades. An economic shock could send TBT and YCS against me harshly and quickly. Strong Asia or central bank demand for gold could push the yellow metal to $1500 or higher again.

And while global investment banks and hedge funds track each other's moves closely, I scramble to pick up bits and pieces of what they are doing so that I do not get run over.

I read as much research as I can and that means I know I am going against some bigger and smarter money in some cases, especially in the gold and yen trades.

But I am willing to take a shot in each trade, with varying degrees of risk, right here, right now. I don't want to chase them later and simply wish I had followed my best sense of global-macro currents and the big trends they create.

I will provide an update on these trades before Labor Day. Until then, please feel free to leave your comments or questions below.

Kevin Cook is a Senior Stock Strategist with Zacks.com where he manages both the Market Timer and Follow the Money portfolios.
 
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