wmeubank@ocp.kcmo.com
A DOSE OF REALITY HITS
THE TREASURY MARKET
Prepared by Jack McIntyre
Strategy
Buy the December 116/112 put spread on the December T-bond for 1-13/64s (current price) or better. This makes break-even 114-25+. There are 37 days until expiration. The current delta of this position is —38. Implied volatilities have been bid up of late which is why we prefer buying put spreads and not outright put options. If the underlying contract closes below major support at 115-00, we expect to see the selling pressure magnified.
Was Greenspan"s testimony to the House Banking Committee yesterday this year's version of the “irrational exuberance” speech? It certainly seems so given the direct bluntness and tone of the speech. Moreover, the reaction in the financial markets suggests that it was as well. We are speculating that this was a very calculated move by Greenspan to remove some of the leverage in the financial markets. We do not mean the type of financial which dominated the U.S. Treasury market back in 1993 when the yield curve was incredibly steep and which was a primary reason for the Fed raising rates the following February. No, we are talking about the speculative leverage which has been in the underlying sentiment of the markets. Bulls abound, which has taken bond yields to levels which are typically not associated with an economy growing above trend (it can be said that the U.S. economy is still experiencing above trend growth for the year).
Back in early December of last year, after the irrational exuberance speech, bond yields backed up from 6.31% on December 12th to 6.90% by the end of January. We do not expect to see the same type of move unfold during this down turn, but keep in mind that the market is a lot “longer” now than it was back then. Just take a look at open interest. It is coming into early October at record high levels and most of the new longs coming in this month are currently “underwater.”
If you look at the CRB Index (and Greenspan does), it puts a bearish or at least less bullish spin on the Treasury market. It is up about 7 points in the last several weeks and with 30-year yields still being near their lows since early 1996, some type of risk premium, inflation premium, call it what you will, needs to be reflected in the long-end of the curve based on the potential for more gains in commodity prices.
October 9, 1997MCM, Inc.
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