The move in bonds has surprised many investors of late. In the face of the impending end of the Federal Reserve’s Quantitative Easing policy that has been in place since the end of 2008, many would have thought, and were positioned as such, that rates would rise. The Fed has amassed more than $3 trillion in debt securities since the beginning of QE :
Regular readers of RiskReversal know where I stand on this. While necessary to keep things afloat back in 2008/2009, the situation since 2010 with “QE’fitnity” has created debatable benefits to some parts of the economy and has always set up for a tricky exit, no matter when it happens. The thing that has benefited the most has been the inflation in asset prices, which is the very thing that worries me as we head into the end of QE. It happens to coincide with a time of geopolitical headwinds that are already wreaking havoc on economic activity in parts of Europe.
Despite the data in the U.S. and the Fed’s stated intent to wind down QE, the yield on the 10 year Treasury is hitting new 52 week lows:
Larry Macdonald of Newedge laid our a very succinct list of reasons why bond yields will not rise in a post on Forbes.com (more detail here), but here were the ones that I thought most important to recent price action:
1. Geopolitical risk: While US government bonds have rallied all year, the turmoil in the Ukraine, Iraq and other hot spots around the world (Azerbaijan, Syria, Israel) have accelerated the flight into US Treasuries
2. Foreign Demand: The Chinese, Japanese and OPEC countries continue to hold and buy US Treasuries as they sterilize the flows of dollars into their countries. Combined, the three hold $2.7 trillion of US Treasuries.
3. U.S. Mid-Term Elections: The mid-term elections in November of this year look to deliver the Republicans their long awaited victory in the Senate.
5. Stalling Global Economy: While the 4% Q2 US GDP growth appeared promising, the rate of growth was measured over the dismal Q1, in which the economy declined by over 2%
10. Global Yield Arbitrage: Talk about an eye opener. Take a look at the yield spread between the 10 Year US Treasury and the German equivalent. The Spread is down at a remarkable -130bps for Germany, the biggest such difference in more than 15 years.
Obviously today’s move has to do with mounting tensions in Ukraine, but I suspect like most geopolitical flare-ups this one will also calm down. Two months ago when it appeared the world and the oil market started paying attention to ISIS’s advances in Iraq, we detailed a way to sell the fear in oil markets, as crude broke out to new 9 month highs, from June 13th:
Oil rallied to new 9 month highs, gold bounced off of 4 month lows, bonds caught a bid, the VIX get a 10% bump off of what felt like all time lows, and SPX sold off ever so slightly. As some pundits blew the dust from the ol’ “risk-off” files, the price movements for the most part were fairly muted. Except for crude oil. The commodity broke through key technical resistance at $105:
Well the situation hasn’t improved much in Iraq, and in some ways has gotten much worse, but crude oil is almost 10% lower. We detailed a trade to “sell the fear” in USO when the Oil etf was $39.20, now $35.45.
We think the situation in bonds could be setting up in a similar fashion after this weeks out-sized 3% bounce off of Wednesday’s lows.
We want to play for a near term re-tracement back to just below the breakout level at $116, and settling in at the prior consolidation in and around $115, but NOT YET. On a Friday afternoon after there has been a flurry of news and spike in volatility, we don’t think it makes sense to put the trade on here, but wait and see how things shake out over the weekend. Ideally we would like one more spike in bonds and then look to put this sort of trade on. When its time, we want to take advantage of the recent short dated spike in vol to sell short dated options to help finance the purchase of longer dated puts that will catch the end of QE at the Fed’s Oct meeting.
Hypothetical Trade: TLT ($117.81) Buy the Sept/Nov 115 Put Calendar 1.30
-Sell TLT Sept 115 Put at .80
-Buy TLT Nov 115 Put for 2.10
Break-Even on Sept Expiration: This trade does best if TLT is at $115 on Sept expiration. If TLT is substantially above or below $115 on Sept expiration, the put calendar is going to lose value between now and then.
Rationale: TLT’s breakout today should be respected in the short run given the uptrend in Treasuries since the start of 2014. However, TLT is now less than 5% away from its 5 year high, so a pause or a retracement here makes sense to us. The put calendar is a trade that plays for a slight retracement over the next month.
One more point, looking at the 3 year chart of TLT, it looks like there is a bit of overhead technical resistance at $120, this would be a nice level to lay out a short biased trade:
Stay tuned as we will look to buy put calendars on a follow through towards $120 on the upside, and possibly raise the strike to $116.