Time to Short Both Long-Term Bonds and Crude

In a conversation with a trader friend of mine yesterday, he casually noticed the seemingly inconsistent manner in which the 10 and 30 year bond climbed as the equity/economy fear trade continued despite oil screaming to $140/barrel. This is counterintuitive considering increased oil-driven inflation expectations should correlate to higher yields, lower bond prices. Of course this ignores the equity market selling hysteria we are seeing.

So I responded (paraphrasing myself more eloquently): 'One of these two markets is wrong. Either bonds fall here, with yields eventually running high to compensate for inflation trending up, or oil collapses signaling the beginning of a deflationary trend. A trade that makes sense is to sell bonds and sell crude here to some spread ratio where volatility and price movement matches.'

I came up with the ratio of 4 ZB (30 year bond futures) short to 1 CL, which represents a ratio of $460K (in bonds) to $140K (in Crude) notional dollars. That's a 3.28 ratio, and considering an average of historic and implied volatility of crude is approximately 3 to 5 times that of the thirty year, this 3.28 ratio is somewhat accurate. The ballpark figures are IV of 30 year bonds at 10% and crude at 40%. Going short TLT 4-5x vs short 1x USO will do the same job for those not doing this via futures.

click to enlarge

The blue line is the performance of the spread. A reversal in crude or a Volcker-inspired policy track will make this a profitable trade. Until some catalyst, this trade will perform horribly if the broad equities market continues sliding while fear ascends. One could consider adding some S&P shorts or puts to the spread. In the long term I do not believe today's price action is sustainable. Looking at the chart on a long term historic basis is not useful, as this 4:1 ratio was not correct 5 or 10 years ago, as crude was trading at $15-30 in that time period nor did it pose the inflationary risk it does today. A correct ratio back then might have been 1 crude short to 1 30 year short as displayed in the green line below (for comparative purposes):

More interesting would be an analysis of the performance of this spread in Volcker years. Here of interest is the red line. I dynamically adjust the amount of crude to stay in a fixed 4:1 cash ratio to that of 20 year maturity bond prices(which is similar to the TLT and 30 year bond future). But after this, you see something indicative of irrelevance of the spread (since oil price fell under control). Ignore the 2002-2006 data, as I entered the 30 year yield as a fixed 5.4% (since the source FRB data here does not include the yield since new bonds weren't floated for that period).

The trick to this trade is figuring out the ratio of 20-30 yr to crude. It should be dynamically adjusted to perform, and could be quite profitable if we do get a repeat of Volcker-like policy looking forward.

The question is: Which breaks first? If jobs continue faltering, the equity fear trade will continue to support low yields. But to me, treasuries have technically been weak, and to me it seems the worst is past. I'd rather not bet on fear at this point in time (reversing course of my earlier bias towards deep recession with ultra-low yields). My hunch is on crude collapsing first (the recession trade). This spread allows you to be wrong if the bid for a technically weak treasuries market does continue to fall. My assertion of treasuries independently:

In conclusion, something has got to break. Either crude is a speculative bubble that will suffer demand destruction from both end users and speculators (as more regulation comes) as they unwind into a recession, and/or central banks eventually react deciding that they want to signal the commodity markets and aggregate demand downwards by hiking rates (as Fed member Fisher signaled in the most recent FOMC meeting, in agreement with ECB hawk talk). This will force yields to strongly adjust upward while continuing TLT's (20 yr ETF, which tracks ZB fairly well) downward technical trend.

Disclosure: Long 30-yr bond and crude oil puts.

Comments

[AAA]

What do you do if you are UltraShort Oil & Gas, and Iran gets smashed earlier than anticipated ? It's tempting but no thanks.

Besides, the ECB will cut rates before the Fed does, and traders will buy more "black gold futures" to hedge against a falling dollar. Dangerous gamble if Japan raises bank rates, knowing that they borrow yen to purchase dollars and speculate.

[User 175766]

Interesting but what about the weak dollar and inlike Le french I believe the EU is inclined to raise rates and screw the dollar in spite of Paulsen's attempts to get the EUand BOJ to buy the dollar and support it.

[fxtrader07]

both markets can be right, actually. treasuries have already fallen and except for oil/energy inflation is quite moderate, as is money supply growth. that's why the bond markets haven't sold off and likely won't do in future.
i think the more obvious and less risky trade is to buy high quality oil-majors like COP and short USO or crude futures against them. because either the oil stocks catch up or oil catches up to the currently uervalued oil stocks

[CLH]

Mike---I hope you are right because I had just started the same trade using similar reasoning. (short oil and short bonds)

fx---I beleive you may be wrong. Commodities tend to run longer then the stocks. I expect oil stocks to turn before oil does. I think the oil stocks are already starting to turn down.

[buyitcheap]

I've posted the "short the long and go long the short" on bonds for some months on this site. I agree with Le French's political risk on going short oil in the face of significant sanction possibilities make it too risky for a DUG play. However, there are several ETF ultra short options for the10 and the 20 year. Best to all.

[galewhitaker]

Since we have passed peak oil and it is a "declining resource" the price will go up for the rest of time, like gold. I agree that if the world economy collapses the price of oil will take a holiday but if things recover the price of oil will skyrocket again.

[AAA]

Sorry ---- I meant ECB will raise rates ---

[Mike K]

Peak oil is a misnomer. The theory should be relabeled "Peak oil at marginal cost of $10/barrel." With that considered, we have tons of oil recoverable at higher marginal costs ($60-100/barrel), still profitable for producers. Now that demand is falling, it kind of undoes the urgency of peak oil, don't you think? The stock markets' behaviors concerning this oil move are signalling that the price of oil will input to collapse economies, thus further invalidating peak oil's significance.

I'm all for getting off oil entirely. With a massive nuclear power plant buildout (and mass production of nuclear facilities) we could achieve an all-electric transportation infrastructure making peak oil worries a thing of the past. Then comes CO2 sequestration to algae ponds from coal production to create more liquids (and double coal's burning efficiency, reducing emissions). Then comes room to destroy a ridiculous ethanol subsidy policy and even possibly *tax* biofue producers for the use of corn and soybean for other than food purposes - this will fix food inflation. All without central banks hiking rates.

The middle east exporters will have trouble selling their 'black gold' for $15/barrel when that happens.

Too bad nobody is listening.

[CLH]

Gale---yes you are right that both gold and oil will go up long term but that is not helpful. Gold hit $800 in 1980 but it took 28 years to return. Thats dead money for a long time. Oil topped also in 1980 and took almost as long to break even. Commodities are never good holds.

[CLH]

Mike K----I agree with you again. My guess is $50 for oil.

[Shaggieman]

Bush needs to pay Hugo a visit and get our COP oil fields back. The American consumer is suffering cause Bush lets our great country be bullied. Our dead war heros are turning over in their graves.

[Mike K]

Nah. Why sink lower and play that game? The best way to solve a problem is change the paradigm. The US could achieve its political desires (weakening of rogue dictator nations?) easily through innovation. Just as the Internet has helped equalize communication freedoms (problem solved through innovation, not government policy) throughout the word, doing as I suggested will solve the funding problem. If you find a way to make oil cost $15/barrel, rogue nations so dependent on oil revenues will suffocate and pose less substantial threats to their neighbors as well as the world economy.

The winner simply plays a new game (innovation).

[Shaggieman]

Tell me where all this innovation is coming from? We don't have centuries to wait you know. Like the following article shows the left hand doesn't know what the right hand doing.

www.nytimes.com/2008/0...

[junkyarddog]

Mike K: I love your out-of-the-box thinking, and long term view. However, your assumption *MAY* be flawded because you may the taking political considerations out of the equation. Notice how many times I used the word MAY, as I really don't know it myself.

Goldman Sachs, Lame-O Bros, JP Morgan and the rest of the gang lost their shirts in the mortgage meltdown crisis. Now they borrow cheap money from the Fed at 2% and invest in oil to recover their losses. And all of this is supported by the political leaders. My point: I don't think there's a willingness to change.

In the long run I think you're right, but at present the political will doesn't seem to be there. Great post!

[Mike K]

Exactly... What a mess. My optimism is probably a decade too early, don't you think?

[Mike K]

junkyarddog: Yes. The fed wants to keep rates low to help the housing market. On the other hand, this may be out of its control, especially with ECB so hawkish, since the market in the end determines long rates. Furthermore, if the inflation genie was let out of bag respective to wages, you would think affordability would go up to support housing versus low rates.

In reality, I'm thinking the short oil side will be likely what performs sooner, as the helium gets let out of the bubble. Massive economic slowdown (which the stock market is shouting) portends to deflation and commodity collapse with falling aggregrate demand.

[jackooo]

If the fed borrowing rate is 2%, why are mortgages in the 6% area?

[Shaggieman]

That's the normal 4% spread the banks need to operate on and pay their CEO + options.

Mike unfortunately time isn't on our side here.

The problem is Hugo doing what he's done makes Bush look like a whip and everyone else want a piece of the chump.

[MNSL]

I think we should sell oil stocks and other commodity related stocks now. This is the greatest period to make profit by unloading your existing investment in commodities. We had more than 7 years of bull market for commodity. We are in the final stage of current commodity bull market.

All hot commodity indexes including oil index will come down soon.

Very soon we will see collapse in the commodity market similar to property market. We are in the bubble stage now.

Oil prices will come down sooner than later.

This is the time to short all hot sectors such as oil and other hot commodities.

[AmesTiedeman]

Nuts. Oil is going to 200. Shorting is a guess on a very short term pull back. Many men have lost it all shorting this oil bull run.

[waldipup]

With all due rerspect to all that there vanalysis -

I don't think I'll try to call the top in oil -

Or in anything else for that matter.

I'd rather patiently wait for unwanted , undervalued entities , and hold them until they are sky high.

Still holding my 1 buck SSRI , 4 buck PAAS , 5 buck GG , .35 BQI , etc.

Don't think I'll try to "catch" the oil top -

Just keep looking for things of value but out of favor

so that nobody else but me wants it , and hold it until everybody wants it - AND WANTS IT REAL BAD !

[pick]

forward looking inflation concerns do not dictate bond yields. "old-school play book may say they do, but this is not the way it works now, bond traders are much smarter than that (supply-demand) , at least i hear Antal Fekete and Michael hudson talk about this often.

Commodity's will soar as long as investment banks keep lapping up the profits in order to repair their balance sheets. Knowing this, The fed won't hike until housing prices stabalize (which in turn will stop the mortgage carnage on investment bank balance sheets) allowing them to be repaired. Upward wage pressure will not gain momentum (sans unions) plus globilization so the Consumer Price inflation and dollar devaluation *may* not be as long lived as the 70's, otherwise the standard of living could fall to levels not seen in anyone's lives (and unrest could reach levels which would justify being veri-chipped). Perhaps the fed copy's the BOJ and leaves rates low for a long time and investment banks reap the rewards until the pressure becomes too great and OPEC drop dollar peg (and war planes fly).

[blink0404]

Interesting take. I believe that investors are just truly confused and uninformed. When the Fed makes statements that they will be tougher on inflation, yields shoot up. When the opposite happens, yields go down. this is exactly the opposite of what should be happening.
Check out this article for a more in depth analysis of what investors are doing and how they are getting screwed by the treasury bonds, which off a lower return than current inflation levels.
www.greenfaucet.com/bo...

[surgcare]

Shorting oil :brave or "STUPID".

[AmesTiedeman]

You may be lucky and right in the short, short term.