Name That Trade $TLT – Short Squeeze… in the Bond Market?

by Enis May 22, 2013 10:02 am • Commentary

I wrote some brief thoughts on the chart structure for TLT on May 10th, and not much has changed from a technical standpoint since then.  This still looks like a rangebound market to me.

But our Fast Money friend Brian Kelly(of fame) has a different view ahead of Bernanke’s testimony today, particularly related to the structure of the U.S. Treasury bond market.  His thoughts:

Get To Work Mr. Chairman Or We May Have a Short Squeeze…in the Bond Market

The olde tyme saying on Wall Street is ‘It’s not the news that matters, it’s the reaction’. The Chairman has repeatedly stated that monetary policy is not a panacea and that fiscal tightening cannot be offset with QE – so far the US equity markets have ignored this warning.  This is precisely why we need to be vigilant today – investors/markets can be fickle friends and when they decide to obsess they can become immune to reason. Be aware that Chairman Bernanke fully understands the deleterious effect of ‘shocks’ and thus BK expects the Bernank will do everything in his power to smooth over any hint of a shock from QE tapering. In fact, BK would expect Bernanke to soothe these concerns….but that may have unintended consequences.

So where should we look for this ‘reaction’?

Look to the Bond Market…Not Stocks

There is something unusual occurring in the murky world of the Repo market – this is the market where US Treasury notes are used as collateral for short term loans. For those interested in more detail on this market, BK highly recommends you read Scott Skyrm’s blog on the subject. What’s important to know is that QE has caused a shortage of collateral – as the Fed’s balance sheet has expanded fewer Treasury securities are available – thus creating a squeeze in this market.  This usually goes unnoticed by most investors since it rarely has more than a one day impact on markets…expect when things go to extremes.

Warning: BK is going to get a little wonky right now.

In the repo market the short term benchmark is the Overnight General Collateral Rate (GC) – the Fed wants this rate to stay fairly close to the Fed Funds rate so that the funding markets remain stable. When the GC rate diverges from Fed Feds it signals a shortage of collateral – this typically occurs in April/May due to US Treasury seasonal funding issues. However this year it has reached an extreme not seen since 2011.

GC Rate (White), Fed Funds Effective Rate (Red)


The GC rate first fell below the Fed Funds Effective rate on May 14, suggesting there was an extreme shortage of collateral in the market – two days later on May 16 the rate went ‘negative’ again…and the bond market had its biggest move in months. On May 16th alone, TLT was up over $5 or 4%!

So here we are again, with the GC rate deeply negative and the Chairman about to speak about ending or extending QE. The talk from Fed officials recently has been that QE could be ending soon, some suggested tapering within the next month. This would be a welcome development for those short collateral in the US treasury market – however it may be to little to late. The market is clearly short of Treasuries and any hint from the Chairman that QE tapering will be slow could ignite another short covering rally.

Is the Market Still Short?

Of course we will never know until later, but the move in Treasuries (and TLT) yesterday suggests the is still a shortage of collateral that is impacting the bond market.  When the GC rate went deeply negative yesterday, TLT turned and burned off the same level it did before the May 16th spike.


This move, when viewed in the light of record highs in equities suggests there are still a significant amount of players that are short Treasuries.

Stay long bonds, my friends.

While I am much less excited about a major move in the bond market in either direction, BK’s discussion is an interesting intellectual exercise.  If BK is correct, then implied volatility in the bond market is likely priced too cheaply.  Along those lines, here is a potential trade for those that agree with him:

  • Buy the June 120 call for 0.95  (TLT ~$117.92)

This is as simple a structure as you can get, but it makes sense for this viewpoint for several reasons.

  1. Implied volatility in TLT is around 13.50, which is in line with current realized, so not expensive.  
  2. Besides the Bernanke testimony and the FOMC minutes today, the next FOMC meeting will be before June expiry, so there are multiple catalysts for such a trade.
  3. Fed officials are likely to continue to test the waters for the next month to gauge the market’s reaction to various commentary, providing more catalysts for volatility
  4. The jobs report on the first Friday in June will be especially closely watched given the strength of the most recent report.

Again, I have no strong view on TLT, and no intent to initiate a new position, but we wanted to provide this discussion for those who are so inclined.