Fed’s Second Round of QE2 – TBT

on 11 3, 2010

For those of you long term readers, you may remember my interest (no pun intended) in watching the Fed’s movement in the bond market vs interest rates.  My overall thesis was pretty simple,  cheap money produced via the Fed’s never sleeping printing press will cause an inflationary cycle that will drive up long term interest rates.  The trick is timing this cycle because we have deflationary pressures from crashing asset classes: homes and mortgages.  Yes, I separated them.  There is a huge mess with mortgages right now that is being swept under the rug.  One reason the Fed is pushing QE2.  Home ownership is the lowest in a decade and shadow inventory( the homes that banks own whether they got them legally or illegally) is over 40 months.  These are the homes that they are not pushing out on the market yet, but really really want to sell them as quickly as possible.   A home is a depreciating asset and a lot of things can go wrong in a home that is sitting there vacant…think busted pipes, vandalism, taxes, upkeep, etc.

Back to the EASING:

If the Fed buys another round of $500 Billion Treasuries then that will drive up bond prices, but decrease the yield or interest rate on those bonds. This is merely a short term cycle, because once the purchase has been made we will go back to the larger cycle at work.

This attempt by the Fed will fail to help our economy, but that doesn’t really matter!

This is the last weapon that our Government has in its bag of tricks because Congress can not approve any more stimulus.  If we had let the natural cycle of economies play out years ago and not propped up bubbles in the first place we would not be in this mess.  The Fed is trying to catch and deflect the falling knife.  They may be able to slow it down, but I am sorry to say the knife must fall in order to clear the bubbles.

What happens when the Fed buys bonds? Interest rates go down… at least for the short term.  How do we take advantage of it.  One way in the short term would be to buy puts in the TBT. I have mentioned this Proshares ETF because it is something I have been watching for the long term trade.  In the short term we could buy an ATM put betting that rates will go down.  TBT is the Proshares Ultrashort 20 Year Treasury currently trading at $33.35.  The low back in August was $29.77.  I am not expecting yields to go below this, so if you wanted to play a quick trade, so could make the bet that the pressure will be on the yields and they will go down, potentially to the low we saw in August.  If  we bought the Dec 32 puts for $1.00,(currently trading $0.97 at last nights closing price of $33.35) then we would only risk that amount.  We would profit if at expiration if TBT went below $31($32-1.00).  The trick here is that we do not want to hold this trade until expiration.  We want the quick pop and get out, because out long term outlook on interest rates is in the other direction.

If the TBT drops to $31by the end of this month, then we should see the Dec 32 puts move upwards in price to about $1.7.  If volatility increases or it moves down quicker then the put value could be higher.  My first target would be $32 and would take small profits, 2nd target would be just below $31, 3rd target would the low just below $30.

Remember, this is not a stock that can go to zero…interest rates are not going to zero. So it is wise to take profits off the table in short term trade as quickly as possible.

If we do get down to the lows, then we should be considering the long term and where interest rates will go.  They may take some time to get there but historical over the past several years, rates have found a home around 6% which correlates to $60 for TBT.  So we want to have a long term buying perspective once the QE2 is cleared out. For this we can look at the Leaps to buy a call but we can go into that in more detail once we get down there.

PST is the 7-10 year proshares ultrashort, and you can look into this if you want.  I have been following the TBT because it has very large open interest and tighter markets.

Please feel free to comment below on the above idea or send me an email.

11-4With the reversal in the ETF already this morning, it has happened much quicker then I thought.

I would reverse this position to go long because people are more concerned with inflationary pressure from this QE2.  We can buy the Jan 35 calls for $1.93.

12/29/2010 If you want to roll you can sell the long call here for $5.35 for profit of $3.42

Wait for a pullback to re-enter.

Jan 3, 2011

Buy the March 37s for $2.62

Feb 7, 2011 Sell the March 37 for $4.2 for $1.58.  Things are getting high.  Aggressive traders should hold onto this.  If you think more inflation is coming hold onto this.

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