Must Yield to Fedestrians – $TLT

by Dan May 20, 2016 2:59 pm • Commentary• Trade Ideas

You know the drill by now, Fed Fund futures went from pricing about a 4% chance of the Fed raising interest rates for the first time since December 2015, and only the second time since June 2006 at their upcoming meeting, to about a 30% probability today. What changed? Well, the Minutes of the Fed’s April meeting made clear that they felt market participants were under-pricing the potential for a raise as soon as June, and questioning their desire to normalize interest rate policy. My thoughts from this morning on the potential of a Fed rate increase in June:

Yesterday, for BloombergViewMohamed A. El-Erian discussed some of his takeaways from the April Minutes. It’s El-Erian’s view that Fed officials were worried that market participants under-priced the potential for a June increase and they wanted to get that sorted a bit with the April gathering. Fed officials sought to correct this misconception, including by spelling out developments that could warrant an increase as early as June. (emphasis mine):

This notable signal reflected Fed expectations that the all-important labor market would continue to strengthen, improving prospects for economic activity and inflation over the medium term.


Officials also welcomed the recent decline in risks posed by global economic and financial conditions. And they noted that the domestic outlook was further enhanced by significant improvements in U.S. and international financial conditions.

The first point about labor market and inflation is likely to remain confusing as the April non-farm payrolls report was well below expectations, despite the unemployment rate hitting the Fed’s previous target of 5%. On the flip-side, just this week we saw measures of inflation tick up at their fastest rate in months and to its highest levels in 5 years, but still below their 2% target.  So your guess is as good as mine what happens at the June meeting if May Non-Farm Payrolls disappoint.

And the second bit I find most interesting. The easing of global economic conditions.  Yep, things were a bit haywire in Jan/Feb, the dollar was at 52 week highs, gold was ripping, stocks got creamed, Treasury Yields made new lows, commodities careened and fear of defaults had high yield credit on the tips of most market participant’s tongues.  With the decline in the dollar in March/April, the subsequent rally in commodities, stocks and yields have clearly eased economic conditions.  But if the Fed is going to raise, will we see the dollar rip again and commodities give back a good bit of their gains from the lows? And will this raise the chance of commodity related credit defaults and/or bankruptcies?

Your guess is as good as mine on this front, but I suspect they do not raise in June and merely speak to the potential of a raise at their July meeting, effectively talking rates higher, while trying to avoid a rip in the dollar back to the 52 week highs.  Last night on CNBC’s Fast Money I suggested they would find and excuse between now and then to push out a hike.

Mark Dow, one of the sharpest guys I follow on Twitter (follow him here, not only smart but witty too), and someone I have been fortunate enough to have help me with the macro goings ons, tweeted the following, which I think is a very important point about the Fed’s intent:

Phrase “excuse not to raise” implies the Fed doesn’t want to raise. Minutes show the #FOMC is looking for “cover to raise”

— Mark Dow (@mark_dow) May 20, 2016

He and I had were able to have a quick discussion following the tweet. Here were some of his expanded thoughts from direct message (emphasis mine):

Behaviorally, people respond less dramatically the 2nd time a phenomenon comes around, as the shock value is no longer there. This should be true both for impulse to USD from Fed stance AND the reaction of other assets to any USD rise.

Yes, the US economy is tepid, but with global growth sitting on our chest it is effectively even weaker. But the Fed does want to normalize. They’re not looking for excuses not to. That many people use the phrase ‘excuse not to raise’ shows how deep our vestigial hard money thinking goes, IMO. That was another era, with a different set of problems. Today, labor markets are steadily tightening and the Fed worries much much more about FinStab. They want to stay in front of that beast as best they can. We’re not the only ones still suffering from PTSD.

And in line with the point about declining recursive effects: Each taper tantrum has been smaller than the previous one. In psychology they call it systematic desensitization, as we get used to the notion that rate hikes (1) won’t kill us and (2) are likely to be fewer and more gradual than previous hiking cycles, which has been the markets’ mental benchmark.

Mark is a pro, especially when it comes to central bank policy. I am an amateur coming from the stock and options side of Wall Street. Where I do think I can add value in this whole discussion is creating a trade structure that offers significant leverage to an upside shock in U.S. Treasuries (and thus a sharp decline in yields).

So let me show you what I see. Whether the Fed is looking for cover to raise or an excuse not to, it is my belief that US Treasury yields are not going anywhere, because no matter what they will remain committed to be accommodative. Its my uninformed opinion that the Fed is unlikely to raise more than twice in 2016, while the risks to economic/market shocks will keep US Treasuries bid, as was the case last August/September and January/February.

Using the TLT (the iShares 20 year Treasury bond etf) as a proxy, the 1o year chart has obviously been in an uptrend, thanks to years of QE & ZIRP, so what gives, because both are over?  (oh and what has been my view of a rolling debt crisis since our financial crisis):

From Bloomberg

The answer is no matter what you think the probability of a June or July 25 basis point hike of the Fed Funds rate, the trend is still obvious. I am hard pressed to think that at this stage of the bull market in stocks, given the back drop of weak economic growth globally, that we are likely too see a material change in the yield trend as our economy (and the global economy) has become dependent on low rates and easy access to credit for the subpar growth that does exist:

From Bloomberg
From Bloomberg

Which brings me back to TLT. A sharp move lower is certainly possible, but as stated above, if we get a summer rate hike I suspect it is not followed by a string of hikes. On the flip-side I see a far greater chance of a sharp move higher in the event that rate increases don’t materialize, coupled with the sort of downward volatility spikes we have seen in risk assets on two occasions in the last year, a sort of flight to safety trade could emerge in US Treasuries.

Options prices in the TLT are very near the 2016 and 52 week lows, with 30 day at the money implied vol at 12%, below the one year average of 15% and the 52 week highs of 18%.

From Bloomberg
From Bloomberg

While absolute levels of short dated options prices are not particularly high given the nature of this etf, (lacking the idiosyncratic risk of a single stock) it still makes sense to finance the purchase of directional bets and not be stuck with decaying premium.

In the event of a sharp move lower in the TLT between now and the end of the Summer, I see it finding support near $125, while the potential for a flight to quality trade could cause a push to new highs in the event of another global growth scare.

So what’s the trade? 

*TLT ($130) Buy the Sept 126 / 133 Risk Reversal for even money
  • Sell to open 1 Sept 126 put at $2.50
  • Buy to open 1 Sept 133 call for $2.50

Break-Even on Sept Expiration:

Profits: above $133, or 2.3% higher

Losses: below $126, down 3.2%, put 100 shares of stock per 1 short contract and suffer losses.

Mark to Market:  between now and September expiration, this trade will suffer losses as the etf moves closer to the short put strike, and provide gains on paper as the etf moves closer to the long call strike.

Rationale:  This trade offers leverage to an upside move that could have happen quickly in the event of broad market / economic turbulence and offers a decent risk reward without committing to owning the etf at current levels.

You might have noticed that the trade has a $3 break-even to the upside, and a $4  break-even on the downside, over the course of this trade the etf will payout about a 25 cent dividend on a monthly basis thus accounting for the $1 differential.