Have Treasury Yields Moved Too Far, Too Fast?

A Bloomberg item out this morning wonders whether long-term Treasury yields have moved too far, too fast:

The CHART OF THE DAY shows the difference between the yields on 10-year Treasuries and the year-over-year consumer price index, known as real yields, over the last 20 years. The gap approached 5 percent yesterday, the most since it was above 5 percent in December 1994, signaling bond investors concerned about inflation have pushed yields too high too quickly, according to Michael Shaoul, chief executive officer at New York-based institutional brokerage Oscar Gruss & Son Inc.

“It seems that while participants have the right idea about the long-term inflationary impact of current monetary policy they have their timing off by several quarters,” Shaoul wrote in a note to clients yesterday. “We continue to believe that long-term Treasury yields have marked their high point for the current phase.” [hat tip, Kedrosky]

Investors who agree with the thesis that inflation expectations have become a bit overblown might nevertheless want to avoid committing to a full long position in Treasury notes. Instead, they can use options to take a defined-risk position that will benefit even if yields merely hold steady at these levels.

Traders could buy the TLT September 90 calls and sell the July 94 calls for a net debit of about $2.95. As evident from the risk graph below, the trade has a better than even probability of being profitable by July expiration, and time decay in the July calls will benefit this trade even if yields enter a period of indecision. Risk is limited to the initial premium paid for the position.

click to enlarge

Comments

[Mad Hedge F...:]

Not fast enough. I have watched many countries go bankrupt over the years, as my collection of defaulted bonds hanging on my wall attests. Governments borrow so much that the cost of the debt service exceeds the national budget, so the country has no choice but to quit paying. I am starting to see disturbing parallels here. Bush took the national debt from $5 trillion to $12 trillion, and Obama will inflate it to $17 trillion by the end of 2010, boosting it to a frightening 82% of GDP. The cost of the borrowing is rising too. Today a 1% jump in bond yields raises the federal interest burden by $50 billion. The Congressional Budget Office says that figure will explode to $170 billion in ten years. Can you see the same hockey stick, hyperbolic, exponential growth in obligations that I do? Interest rates will soar to double digits, the dollar will crash, and private borrowers will get crowded out of the market, taking the economy into the tank. People blanche when I tell them that my target for the PowerShares US Lehman leveraged short government bond ETF (TBT) is $200, but the logic is inescapable.

Jun 18 11:57 AM

[Condor Options:]

Unless your time frame for that $200 TBT target is within the next few months, nothing in your comment is inconsistent with the trade profiled here. Thanks for the comment.

Jun 18 12:10 PM