Sunday, June 13, 2010

Where do Interest rates go from here?

So Jason and I recently attended the traders expo in LA this past week and had the opportunity to meet a few of the people that we talk to in the online trading community. It was really nice to put some faces to names. We also had the pleasure of meeting a few new contacts that will beneficial going forward. One such person is Tom Sosnoff of Think or Swim. During his presentation he brought up interest rates in the United States. He started off by asking the audience "How many of you think interest rates go down more" (most believed interest rates were going up), in my head and under my breath I said they really could not go down from 0%. I do realize however that this is just the short term fed rate and all other interest rates are based on this number plus some spread. But my main thought was that I didn't think there was much more downside in interest rates on longer dated treasuries like 20 year. Next Tom asked "How many are short bonds?", and 1 person out of 400 raised their hand. To me Tom was asking all of the right questions. Anyways to make a long story short I liked the idea of getting short bonds via the TLT which tracks the 20 year treasury index put out by Barclay's.

So I did a little homework to see how well this ETF tracked the index and ran the numbers back to January of 2007 for both the rates on the 20 year treasuries as well as the performance of TLT over the same time period and constructed the chart below. I basically was looking for a mirrior image when plotting the TLT vs the 20 year interest rate. I got exactly that:



So to me this helped me decide that the TLT would be a great product to make a play on interest rates. Next I crunched some numbers to see what the average move in TLT was for each move in the 20 year rate. Since 2007 TLT has moved about 13 times the move in the underlying interest rate. I wanted to calculate this to try to help come up with some price objectives on a increase/decrease in the 20 year rate with respect to the price of TLT. The 1 standard deviation was about 8. So 68% of the time I could expect the TLT to move at least 5 times to 21 times the movement in the actual interest rate.

I would like to take a short position in the TLT ETF but will need a little more time to construct the trade. I just wanted to get this analysis out of the way. What do you think of this trade and interest rates in general? What might I be missing in this analysis?

2 comments:

  1. I thought the trade idea was so simple that it made me feel stupid. Just another example of not being able to follow every idea all of the time. However, this one kind of sticks out as very low risk trade, the question is, how do you quantify the return? Without knowing when or how much interest rates will change, it's kind of hard to model a trade.

    For instance, obviously at near 0% you can't go any lower so it sounds like a good time to put this trade on. But had you done that two years ago, you wouldn't have made any money yet. So one argument is that since we don't know when or by how much rates will change, it's hard to propose a trade. The second argument is that since rates haven't moved in two years, don't we kind of have a freebie at the moment in that we weren't sitting around on a trade going nowhere the last few years and can put it on now. The third argument is Japan, what if we stay at near zero rates for ten years?

    Where I'm going with this is that since we don't know when or by how much rates will change, I would not buy puts or even a put spread because I don't want to give up any time premium. I think just taking a short position in TLT is better since rates can't go below 0%, implying that a short position can only run against you so much and for so long. That being said, who would have ever thought rates would go negative, which they did for a spell during the crisis as people literally paid more than face value for t-bonds just for the security of parking their assets.

    I don't know a lot about this TLT instrument so I need to do some homework. I know if you're short a stock that pays a dividend then you as the short holder have to pay that dividend. I don't know how a short position in TLT as opposed to owning puts works. I don't know if there is anything else to consider.

    To me the moral of this trade idea was not necessarily this specific trade idea. It was the rational and thought process behind it, and if you can take that philosophy and apply it to all potential trades then you're a step ahead of everybody out there that isn't (which was me for years). And a step ahead, or slight edge, is literally all you need to be a profitable in this game.

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  2. When I first posted this analysis rates on the 20 year treasury were at 4.05%. Today they closed at 3.74%. I think Jason's trade long via call spreads and short put spreads to offset the cost of the call spreads makes a lot of sense in this environment. The premium collected from the puts spreads help finance the call spreads incase you are wrong on the spead of the move.

    I do however think that we will eventually get to a point where rates will get to a level so low that it will make sense to try the sale of call spreads again. Is that at the low seen in 2008 of 2.8%? I don't know...but at 2.8% TLT should be trading about $120 so that leave some nice room to the upside. Do you play it to the long side up unitl 120 and start shorting there? At some point I think all this debt that the US, and the world for that matter that keeps piling on that rates are going to have to eventually go up. With the outlook of the economy we may eventually start hearing about "stagflation".

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