Tomorrow the Federal Reserve will meet in their third to last meeting of the year. Fed Fund futures are implying about a zero percent chance of a raise tomorrow or at their November 1st meeting but more than a 50% chance on Dec 13th. As the WSJ put it this am:
And the article detailed the dampening effect on interests rates with QE after QE during the recovery:
So on the eve of what is likely to be the start of the messaging of Quantitative Tightening should investors be worried about interest rates rising too quickly, possibly shedding light on historically high valuations for stocks? In the near term, with the S&P 500 (SPX) up 12% on the year, at all time highs, and with the S&P Volatility Index (VIX) near multi year lows at 10, investors are not betting that stocks will fall apart or that rates won’t rise too far too fast. The 10-year treasury yield as of a couple weeks ago had round-tripped most of its post-election move, but after the sharp bounce it appears to be at near-term technical resistance:
Taking a longer-term technical view back to 2000, last year’s sharp bounce in rates broke the long-term downtrend that had been in place since the dotcom bubble burst and pre-financial crisis. The recent retest and bounce comes right at the financial crisis low, and there is a pretty obvious double bottom that some have called (Doug Kass for one) a “generational low” in Treasury yields:
Next stop 3%?
If you think so, using options with defined risk to position in the TLT (the 20 year Treasury bond etf) is one way to play. As Treasury yields pressing up against technical resistance, bond prices (naturally) are sitting on technical support:
Short-dated options prices are cheap, on a relative and absolute basis, with 30 day at the money implied volatility (blue line below) at just 9.3%, down almost 50% from last years 52 week highs, and actually below 30 day realized volatility (white line below, how much the etf has been moving):
If I were inclined to play for a re-test of the 52 week lows in the TLT, I would target Dec expiration, that captures the Dec Fed meeting, targeting the Feb low just below $117.
So what’s the trade?
TLT ($125.80) Buy the Dec 125 / 118 Put Spread for 1.95
- Buy to open 1 Dec 125 put for 2.30
- Sell to open 1 Dec 118 put at 35 cents
Break_Even on Dec expiration:
Profits: up to 5.05 between 123.05 and 118 with max gain of 5.05 below 118
Losses: up to 1.95 between 123.05 and 125 with max loss above 125.
Rationale – Quantitative tightening begins and it may be enough to send TLT lower through support. If it doesn’t and the bond market throws us a surprise, risk is defined.