Treasury Bubble Part II: Three-Month Yield Turns Negative

by Phil Streible & Richard Ilczyszyn

Risk-aversion has been driving investors, and they have been rushing into U.S. Treasuries. Yields have been pushed down to historic lows across the yield curve, and in an unprecedented development, three-month Treasury bill yields have actually turned negative. The Treasury bubble is blowing up, but we think the air will eventually be let out. We recommend buying puts in the Treasury bond and note futures now. Investors will lose their fear as the stock market improves, and the safe-haven play dominating the markets over the past couple months will likely be unwound. It could result in a significant move lower in futures prices, which trade inversely to yields.

The 30-year Treasury bond yield has been hovering near 3 percent, while the 10-year Treasury note yield has seen its lowest levels in half a century, falling to 2.505 percent on December 5. 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 investors are afraid the economic recession will deepen and aren’t terribly confident in the stock market.

A bubble is clearly growing in Treasuries. Some analysts say Treasury yields could drop even more, but we don’t think this trend will continue much further into the new year.(Chart of 30-year bond yield and futures price shown below.)

Right now, we recommend buying the March 2009 125 Treasury bond put and selling the March 2009 120 Treasury bond put, which expire February 22, 2008. These options give you enough time to take advantage of an abatement in investor fear and optimism the economy will turn around next year.

With options, you don’t have to worry as much about the timing of the trade as you do with an outright futures position.You can be in the trade for several months without being stopped out if the market continues its current trend a while longer. The March 30-year bond is currently trading just above 133.

The cost of the option spread would be approximately $1,050, plus your commissions. That is your defined risk on the trade. We 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 1300 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, we think it could fall like a rock.

At the far short end of the yield curve, rates are at rock-bottom. In a crazy development, the yield on the three-month Treasury bill fell to -0.01 percent on December 9, 2008.The government sold $30 billion of four-week bills at zero percent for the first time since it began selling the securities in 2001. We are not only headed toward a zero-rate policy, it looks like we are already in it. Investors seem more worried about putting their money in the bank, than with the government. (Three-month T-bill yieldshown below)

The key U.S. short-term interbank lending rate known as the Federal Funds rate is now at 1 percent, but some market participants expect it to drop to as low as 0.25 percent when the Federal Open Market Committee convenes on December 16. Federal Funds Futures are pricing in 100 percent odds for the rate to fall to 0.25 percent, up from odds of under 40 percent just a week ago.

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

Phillip Streible is a Senior Market Strategist with Lind Plus. He can be reached at 800-803-8037 or via email at pstreible@lind-waldock.com.

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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