A Pause in Treasury Yields

Thu, Jun 18, 2009 | Jared Woodard

Bonus Trades, Inflation

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.” [link, h/t 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.

tlt-6-18-09

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