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The Yield Curve Trade (TLT)

02/21/13 by  
Filed under Bourbon & Bayonets

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Some fancy-pants at a bigwig brokerage recently dreamed up with the term “The Great Rotation” to describe a phenomenon that we’ve grown hoarse yelling at y’all for the last two years.

The idea is simple, and it goes like this.

The 30 year bull market in U.S. Treasuries is coming to an end, interest rates are set to back up significantly (due to pending inflation from all the liquidity in the system) and money will therefore shortly be exiting the fixed income arena for lusher pastures in equity land.


Truth is, we wish we’d thought of the term ourselves.

Alas, our pants just aren’t fancy enough.

Enough bourgeois blather, McAbby!  Get on with it!

Coming up with catchy phrases is not our first order of business here at Bourbon & Bayonets.  Oh, no.  We’ve rather been charged with the Atlas-like task of educating and entertaining our vast readership toward better investment returns in what’s shaping up to be perhaps the most difficult era to partake in the money game.

And with a few minor exceptions, we feel we’ve done our part reasonably well.  It’s with genuine humility that we report that our direction and recommendations have been uncannily and consistently on the mark.

So if we’ve succeeded in convincing you that a long stock market position – despite the fiscal cliffs and debt ceilings, the hard Chinese landings, the Greek and Spanish and Italian and Irish sovereign debt imbroglios, the Arab springs and whatever the hell else you want to throw in there – was the right thing to do, then we’ll be partially satisfied with our work to date.

By the way, this is what you were worried about exactly one year ago:


Be happy.

Where we may have fallen short, however, is in convincing you of the need to be out, if not outright short, of the fixed income field.

In truth, we’ve devoted a good measure of space to the issue and have written with increasing urgency on it, too.  But it appears the laggards amongst you require yet another tear of the lash before they understand the sweet truth of the upcoming bond bear.

So here goes.

Let’s begin with the following incontestable fact.

When interest rates rise, longer term bonds sell off in more violent fashion than shorter term bonds.

We won’t get into all the mathematics of it.  Just suffice to say that the risk associated with holding a fixed rate, long term instrument in a rising rate environment will prove more costly than that of a shorter duration, because the short term bond can be reinvested at a higher rate earlier.  The opportunity to catch a better rate of return sooner in the process makes the current value of that instrument less subject to the volatility that obtains with longer term instruments.

And, of course, there’s money to be made from this understanding.

Yield Curve Rising

Let’s broaden our understanding somewhat with a look at the U.S. Treasury yield curve for 19 February, 2013 (Tuesday), on a chart that indicates both nominal and real yields offered for all durations.


[The Treasure Department offers the above chart here for all interested.]


And what do we see?

First, that investors have to go out nearly twenty years (red circle) to get a positive rate of return on their investment (real yield is nominal yield less the current rate of inflation).

This in itself is almost unfathomable.  It means that the vast majority of bond buyers today are prepared to purchase an asset that will lose money over time (due to inflation) in return for the ‘guaranteed’ return of their principal.


That’s what we call a cataclysmic mindset.  And because bond yields are backing up, those same petrified bond-holders will see their apocalyptic fears eventually become a reality.  The value of their bonds will plummet – again, with the long end of the curve seeing the worst of it – and they’ll lose out to inflation, while the opportunity to more profitably deploy those same resources will be lost.

Big Players Repositioning

The banks and brokerages, on the other hand, have recently repositioned themselves for the coming storm, reducing their duration and thereby eliminating much of their reinvestment risk.  As short term rates push higher, they’ll be better configured to regularly turn over their maturing funds into higher rate bearing instruments.

And that, for us, makes the trade abundantly clear.

Have a look at the long term (20+ Year) Treasury bond ETF (TLT) against the 3-7 Year (IEI).


Since mid-summer IEI has lost just over 1% of its value, versus 11% for the long bond, TLT (red circles, at top).  And TLT’s Relative Strength Indicator is nowhere near oversold (at bottom, in blue), signalling there could be plenty more selling down the road.

Given all the foregoing, we see no reason why the trend shouldn’t continue.

A long/short trade using IEI (long) and TLT (short) will cost you about $6 per share paired.

It’s worth a look.

There’s a bid for the short end of the curve.

There ain’t nothing out at the end.

Many happy returns,

Matt McAbby, Senior Analyst, Oakshire Financial

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9 Comments on "The Yield Curve Trade (TLT)"

  1. Andy on Thu, 21st Feb 2013 9:42 PM 

    Bids on the short end of the curve not sufficient to support decline. Why bother with the long position on the shorter maturities? Still not a positive yield. Why not just short the longer end? What am I missing besides the hedge?

  2. Dane Howell on Thu, 21st Feb 2013 10:44 PM 

    TLT is controlled by Bernanke – not a real mkt (FED and the 19 broker-dealers are the only buyers of our debt). You guys assume real mkt principles, if that was the case TLT would be at 65 (due to lack of buyers of our debt because of our $122T unfunded liabilities, 105% debt/gdp, & real inflation that Fed hides).

    10yr yield sitting at 2% and mkt up 7% since Dec 31 (s&p 1502)- TLT has just sat there sideways for weeks now and started sideways before s&p started sideways(daily and volume chart actually looks like its headed back up short-term).

    Only way Bernanke let’s TLT float freely – i.e. stop buying all new govt issuance – or it gets out of the FED’s control is

    A) Congress gets a simpsonbowles type plan in place that sets a long-term debt/gdp trajectory at 70% or less

    B) Congress does no deal and we keep flailing around trying to buy time and world does a few things to that take away US Dollar world reserve status – starting with obvious and upending US dollar based oil.

    C) Hyperinflation/US dollar collapse – but FED never let the natural phase of deflation work through the system right after Great Recession – AND THE DOLLAR IS ON A BULL RUN – so not anytime soon…

    Question for you is if Hyperinflation does happen down the road – will the stock mkt inflate to keep up with asset inflation or will it do like all other past hyperinflation countries and tank with the currency (Argentina, etc)?…

  3. David K on Thu, 21st Feb 2013 11:57 PM 

    Dead on….its a winner for sure

  4. Joel on Fri, 22nd Feb 2013 1:33 AM 

    Trade working again! You guys rock. You’ve been on this one awhile now.

  5. Mike on Fri, 22nd Feb 2013 9:44 AM 


    You do go on and one. And you are right! That said, this really is not so complicated. We’ve been there before in 1934. This recovery was assured with the reelection of Obama and the gains by Democrats in the Senate and the House during this last election. Now come 2014 or 2016, the Republicans will lose their majority in the House and the Democrats (probably under Hillary), will finally get to full speed in ending the inequality that has exploded since we let the foxes back into the hen house with the Republican Revolution in 1982…

    There is an old saying that “America does best when All Americans do better” I.E., as inequality increases market falter and as inequality falls markets flourish… Stiglitz just wrote a whole book on that very subject and it is a best seller…. :)

    We’ve just seen history repeat it’s self and we are watching the newest “New Deal” unfold…. Those of us that recognized this historical political and follow-on economic turn, went long March 2009 with the passage of PIPP by the Obama Administration (part of the new “New Deal”)and are still long the equities and will be for the next 40-70 years because we remembered what Kondrotiev forecast in 1923…..

    Enjoy the rebirth of the Middle Class and the rebuilding of America. Enjoy the victories of the Common Citizen and don’t fail to forget the lessons of 1929 and 2007……

  6. dave reeves on Fri, 22nd Feb 2013 10:06 AM 

    I like the tlt/iei trade. I’m a little more comfortable with that than the tbt trade.

    Question, though. Did you recommend iyt calls a while ago. I bought some. I think I sold when I doubled. I’ve been watching. Are you still in? It really doesn’t matter to me. I was mostly wondering if you recommend the sale when you think appropriate. Or are we on our own? Thanks, Dave

  7. Bill Power on Fri, 22nd Feb 2013 4:01 PM 

    Why don’t you just own the Pro Shares TBF? It’s not leveraged. It’s inverse by that I mean Inverse bond ETFs are designed to move opposite bond prices tied to their benchmark indexes. It’s not that expensive to own.

    We think that LT rates are going up. We don’t know when. Too complicated to go into yield curve.

  8. Stephen on Fri, 22nd Feb 2013 5:31 PM 

    jury’s not in on (TLT), just the “urban legend”. Ask us what we’re afraid of, Fed might pull something out of it’s hat to save treasury yields?

  9. Andrew Shook on Fri, 21st Jun 2013 6:08 PM 

    Matt, thanks for writing about the yield curve, its importance and the relationship to other assets.

    But, COME ON MAN (shout out to @PTI), you can’t short TLT or any other iShares government bond ETF. You are absolutely correct that yield curve trades require a long leg and a short leg. Your post seems to recommend a yield curve steepener which is long the front leg and short the back leg.

    The KEY to a well structured yield curve trade is a DV01 (dollar value of a basis point) neutral front leg and back leg.

    A 1:1 ratio is nothing better than a punt on longer duration rates. DV01 and duration are closely related. More duration, more DV01 and hence more price volatility. If the yield curve shifts up 25 basis points in a parallel manner, TLT will trade down in price significantly more than IEI, but the YIELD CURVE SPREAD will NOT change.

    This is why the hedge ratio is critical.


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