The Treasury Bubble

By Richard Ilczyszyn

The fear and the volatility we’ve seen in the past few months in the stock market has driven investors to safe-haven instruments like U.S. Treasuries, and prices for Treasury bonds and notes have soared. It’s looking like the next big bubble. Like any bubble, I think it will eventually burst. I recommend buying puts in the Treasury bond and note futures now, as these markets could come down hard, and fast. As it’s impossible to say when that will happen, options are a good way to allow you more flexibility in the timing if the bubble continues to build a while longer. You’ll also have the benefit of defined risk.

Treasury prices and yields trade inversely to each other, so as prices have skyrocketed, yields have dropped to historic lows. The 10-year Treasury note yield has seen its lowest levels in half a century, falling under 3 percent. The 10-year Treasury note yield even briefly fell below the dividend yield on Standard & Poor’s 500, which hasn’t happened either in 50 years. This is certainly a sign the stock market is cheap right now, and that a bubble is forming in Treasuries. Some analysts say Treasury yields could drop even more.

Rates at the far short end of the yield curve are about as low as they can get, and there have been numerous articles in the press drawing parallels to Japan’s zero-rate policy. The key U.S. short-term interbank lending rate known as the Federal Funds rate is now at 1 percent, but is expected to drop to as low as 0.25 percent when the Federal Open Market Committee convenes on December 16.

As the stock market, unemployment, and the housing markets settle a bit, I feel money will come off the sidelines, out of Treasuries back into undervalued assets. Right now, I recommend buying Treasury bond March 2009 122 puts, which expire February 22 and you enough time to take advantage of an abatement in investor fear and optimism the economy will turn around next year.

The cost of the option would be approximately $1.546, plus your commissions. That is your defined risk on the trade. I picked this strike because of its favorable delta (defined as the ratio of the change in price of an option to the change in price of the underlying asset), and the fact this price is 300 points above the 50-day moving average. The 50-day moving average tends to be a price target the market will gravitate to. The market is technically overbought, and when it retraces, I think it could fall like a rock.

Feel free to call me for more specific strategies in this or other markets to suit your individual risk tolerance, and ask about a special half-off offer for new clients.

Richard Ilczyszyn is a Senior Market Strategist with Lind Plus. He can be reached at 800-605-0095 or via email at rilczyszyn@lind-waldock.com.

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