With all so many major news items hitting the wire these days, it’s easy to overlook more mundane topics like interest rates. After all, we have record setting hurricanes, massive forest fires, and the debt ceiling debate, just to name a few topics from the past week. But buried underneath all of this (admittedly important) news, expectations of interest rates are changing.
At one point (just a few weeks ago), it was a foregone conclusion that the Fed would raise rates at least one more time in 2017. Now, the earliest the market expects a rate increase is December, and it’s only assigning a 30% chance of even that happening. We very well could be in 2018 before the next rate hike.
At least part of the reason for the delay is related to the extreme weather conditions. The cost of cleanup/repairs will be massive. The Fed doesn’t want there to be concern over rising rates when people are trying to rebuild their lives – especially if the money has to come out of pocket and not from insurers.
But, that’s just part of the reason. The most recent jobs report for August was worse than expected, suggesting the economy may not be growing as fast as expected. More importantly, recent inflation numbers are not increasing as expected. If inflation numbers remain low, there really is no reason to raise rates.
(A quick economics lesson: Higher interest rates are used to combat inflation when it gets too high and erodes buying power/quality of life. If there is no threat of harmful inflation, then there really isn’t a reason for the Fed to be aggressive about higher rates.)
Here’s the thing…
As the possibility of a 2017 interest rate hike decreases, the price of bonds has been increasing. This makes perfect sense since bond prices and interest rates have an inverse relationship. However, there could be quite a bit more upside potential in bond prices.
The chart to the right shows the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT), one of the most popular bond ETFs. You can clearly see the recent uptrend in bond prices. Nevertheless, a big trader believes more upside could be coming in the next several weeks.
This trader purchased 15,000 TLT 130-135 call spreads expiring October 20th for $1.15. That means the trader bought the 130 calls and sold the 135 calls at the same time to reduce the premium cost. Break even for the trade is $131.15, while max gain is $3.85 if TLT closes at or above $135 on October expiration.
What’s interesting about this trade is the number of contracts traded. The trader is spending $1.7 million in premium on this bullish bet. That’s obviously not a whim, and suggests there could be real upside ahead in bond prices.
If you think going bullish bonds is the right play, a call spread in TLT is a good, relatively cheap way to gain exposure. The only slight variation I’d make is changing the strikes. Instead of buying a 130-135 call spread, I’d look at buying the 129-133 call spread.
The call spread I recommend costs roughly the same, around $1.15, but lowers your breakeven point to $130.15. The drawback is max gain falls to $2.85. Still, I prefer the higher probability of success as a tradeoff for lower upside potential. Moreover, I’m not sure I believe TLT will get all the way up to $135, and I see $133 as a more realistic cap.