Last week in this space (MorningWord 5/5/16: Bail Bonds – $TLT) I had some thoughts on the direction of U.S. Treasury yields (below). Regular readers know that I have been fairly steadfast in my belief that the U.S. Federal Reserve wishes that they had normalized interest rates because at this stage of the game they find themselves in a fairly difficult spot as they have already done an about-face on their late 2015 hawkish action. After Friday’s weak non-farm payrolls data, Fed Fund futures are now pricing in a 4% chance of a raise at their June 15th meeting a 15% chance of raise in July and slightly less than a 50% chance of a raise in December. So it’s not just me. Most market participants think the Fed is on hold for 2016 and even if they were to do another 25 basis point raise at some point this year, as they did last December it would be nothing more than symbolic and a weak grasp at maintaining whatever credibility they have left.
My view from last week’s post was that options on the TLT, the iShares 20 year U.S. Treasury Bond etf are likely some of the cheapest vol on the board if you are in the camp that rates continue to go lower, possibly below the zero interest bound where $8 trillion of global sovereign debt now presides. Which is why trades like the one that printed this afternoon in TLT catch my eye.
When the TLT was $131.77 a trader sold to open 12,000 June 127 puts at 55 cents and bought to open 12,000 June 135 calls for 88 cents. A risk reversal. This trade structure costs 33 cents, or $396,000 in premium. The trader has created a fairly wide band where the risk is the premium paid, between $127 and $135 on June expiration the trader loses the $396,000. Below $127 the trader would be put 1.2 million shares on June expiration and have losses below. On the upside the trade breaks-even at $135.33, up 2.7% from the trading level, above the 52 week highs:
So what could go horribly wrong for this trade? If the Fed started floating a trial balloon that they are considering a raise at their June meeting, and you might see traders fall over themselves to sell U.S. Treasuries as they are woefully off sides. But that doesn’t seem likely
MorningWord 5/5/16: Bail Bonds – $TLT
9:47 am EDT – May 5, 2016 By Dan
Raoul Pal, the founder of the Global Macro Investor, is one of the few guests we have on CNBC’s Fast Money program that connects macro dots back to the stock market in a way that even a monkey like me can understand. While he is not a frequent tweeter, this one caught my eye yesterday:
US 10 Year Bonds – IF this trend line goes, bond yields should fall sharply from here… pic.twitter.com/sVWvXbPLiC
— Raoul Pal (@RaoulGMI) May 4, 2016
That is a purely technical take. But it’s significant when you couple that with his fundamental view of the global economy, a U.S. economy in danger of a recession in 2016 and a U.S. Fed that would consider negative interest rates. Watch his thoughts on a paralyzed Fed from earlier this year, February 25th, 2016:
From a timing perspective, he made an amazing call in late February as he said we are likely to enter a period of calm, with equity markets drifting higher. We’ve certainly seen that. But he said that eventually the chickens would come home to roost as he sees oil and commodities lower, yields lower and dollar higher. And that’s why Pal’s tweet yesterday, in front of tomorrow’s April non-farm payroll’s is kind of interesting, as the weak dollar since this video has helped commodities rip higher, easing credit concerns, bringing about that calm he foresaw.
Since Pal’s last appearance, the Federal Reserve has pushed out rate increases, doing an about-face on their first increase of the Fed Fund rate in 9 years back in December, and futures are now pricing only a 10% chance of a hike at their next meeting in mid June, and a 52% chance of a hike in December:
The last time we had Pal on, the Fed Fund futures were implying a 24% of a June hike, and a 36% chance of a December hike:
Looking at the chart of the 10 year U.S. Treasury yield, there’s not much constructive about it technically. Short or long term. And its inability to get back to the downtrend (that has been in place since early 2014) shows the structural bid for U.S. Treasury bonds. They seem to weather all sorts of news. Probably the only thing that’s constructive about this chart is the possibility for a bounce back at 5 year technical support near the 1.5% bound:
So for those who share Pal’s gloomy take on the global economy, and the likelihood that U.S. Treasury yields go lower, it might be worth taking a look at options in the TLT (the iShares 20 year Treasury Bond etf). Since 2011 has been in a well defined uptrend, making a series of higher lows and higher highs:
In the sub 20 VIX world that we live in, 12% implied volatility may seem expensive for options on the TLT. But at this stage of the game, with equities being the only game in town, if there is anything lurking in a financial world fraught with landmines to shake that view, global investors will reach, and then reach again for U.S. Treasury bonds, and 12 vol could easily go to 25 vol:
Long TLT remains one of the safest trades on the board. And you don’t need to wake every morning from a Zerohedge doom-bunker for that to be true.