In case you missed it, U.S. Treasury yields have been on the rise, with the 10 year at 2.15%, above the dividend yield on the S&P 500 (SPX) for the first time in a long time at 2.04%. Fed fund futures are currently pricing an 84% chance of only the second rate increase since June 2006 at their December 2016 meeting. I suspect the Fed will fail to make the same mistake as they did last December, when they last hiked, by signalling 4 further rate increases in 2016.
The fact of the matter is that global investors panicked in January and February as they priced in the potential for a rate increasing cycle at a time when the global economy seemed fragile and divergent monetary policy with the rest of the developed world might increase the odds of a global recession. Even while financial conditions cooled in Q2 from near panic levels in Q1, Treasury yields made new all time lows. This was a clear sign of the lack of investor confidence in the Fed’s monetary policy.
This week’s ramp in Treasury yields was fairly epic with Wednesday the largest one day percentage gain on record, which resulted in a fairly epic technical break in the TLT, the iShares Treasury Bond etf:[caption id="attachment_68075" align="aligncenter" width="600"] TLT 5yr chart from Bloomberg[/caption]
Swapping back to the 10 year yield, as peeps try to predict where it can go, well there is a trad bit of technical resistance at 2.5%, with 3% seemingly a long shot in the next couple months as the Fed is likely to remain fairly stubborn on the prospect of a series of hikes in early 2017:[caption id="attachment_68077" align="aligncenter" width="600"] 10 year U.S. Treasury yield 5 year chart from Bloomberg[/caption]
Lastly the 30 year chart of the 10 year Treasury yield kind of shows a fairly obvious trend:[caption id="attachment_68106" align="aligncenter" width="600"] QO year Treasury yield since 1986 from Bloomberg[/caption]
I guess you have to ask yourself whether or not we are on the cusp of an epic counter trend move? And what has exactly changed in the last few days that points to such a massive shift?
Its our sense that too quick of rise could have an adverse economic impact, and stocks could become vulnerable if investors start to focus on valuations, and risk reward vs dividend yield of SPX vs Treasuries.
Short dated options prices have spiked with the TLT’s decline of late, making long premium directional strategies a bit challenged.[caption id="attachment_68088" align="aligncenter" width="600"] TLT 1yr chart of 30 day at the money Implied volatility from Bloomberg[/caption]
For those who think the rise in treasury yields could moderate, and that the recent euphoria in stocks and other risk assets might abate, and the new year could see some volatility, a move back into Treasuries could be the target for those looking for a safe haven.
So What’s the Trade? As we said above, owning premium in a low vol etf like TLT, after sharp move in price, and vol, it makes sense to finance directional views.
TLT ($122.25) Buy Feb 116 / 127 Risk Reversal for even money
- Sell to open 1 Feb 116 put at 1.75
- Buy to open 1 Feb 127 call for 1.75
Break-even on Feb expiration:
Profits: above 127, up about 4%
Losses: below 116, down about 5%
Mark to Market: as the etf traders higher towards the long strike the position will gain in value and will lose value as the etf moves lower towards the short put strike.
Rationale: The idea here is to initially spend no premium, have leverage to a sharp move to the upside, while the worst case scenario would be a decline in the etf below $115, a two year low, which should serve as technical support:[caption id="attachment_68089" align="aligncenter" width="600"] From Bloomberg[/caption]
Also targeting February expiration as it seems like a near certainty that the Fed will raise at their Dec 14th meeting, but depending on how Washington’s transition is going, and what is the state of “financial conditions” as the Fed cited in early 2016 as the reason they did not raise again, we may see a push out of increases. In that case, Treasuries would once again catch a bid.