The U.S. Treasury Department makes money the old fashioned way - they print it. The Treasury markets are a direct reflection of the economic analysis of the U.S. but as markets tend to overreact to stimuli, prices and resulting yields usually return to normalcy. That is the basis for all markets but specifically the Treasury market. The Federal Reserve in its wisdom, or lack thereof, raised the Fed Funds interest rate 17 times from 1% to 5.25% from June of 2004 to June of 2006 without the benefit of reaction to prior increases. For that blame Alan Greenspan, the former chairman of the Fed. Unfortunately, the new chairman, Ben Bernanke, was left with the monumental job of re-evaluating the result of the unrestricted rate increases and decided to lower rates. Now we are left with a recession, whether or not it meets the official description of two negative growth quarters.
Prices for Treasuries will move with economic data. The 30-year Treasury bond is a $100,000 instrument with a 6% coupon. That means any rate below 6% translates to a price of over 100, and subsequently a yield more than 6% would mean a price under 100. The current price levels reflect an interest rate of 2.5% and a price of 116.
The equity, bond and commodities markets are all intertwined but the common denominator remains the U.S. interest rate, its relationship with the rates of its trading partners and its impact on the U.S. dollar. As the preferred currency of the world and as the U.S. is the consumer of the world, the fortunes of the U.S. dollar impact not only the U.S. economy but those of its trading partners.
In assessing the current U.S. economy we can only conclude that we are in a recession, albeit not officially. However, a new factor has been injected into the economic landscape, that of the subprime mortgage. What is it? It is a mortgage predicated on the application of fictitious interest rates and the unprecedented ability to allow homebuyers to purchase homes they could not afford with little or no down payment. The basis for such ambitious lending practices is the annual increase in property values that under past conditions afforded a measure of security as values increased and created equity to offset the fact of no original equity.
What will be the overall impact on the U.S. economy, the U.S. consumer, and the producing nations that have thrived on the ability of the U.S. consumer to purchase their products? Financial Armageddon? Not quite. The resilience of international economies always correct but we could get critically close. How does an investor deal with the prospect of a prolonged global recession?
First, take advantage of the low long term rates established to try to stimulate the economy. Second, look for a clean out climax of existing bad loans and assess the damage to the U.S. economy and the U.S. dollar. Any sign of that base formation would prompt a look at the long side of the dollar against those currencies that will take longer to recuperate from the current debacle. Another factor to consider is the sale of commodities that have overextended themselves pricewise based on true fundamentals. While no one can claim to catch tops and bottoms in any market, the use of options for entry into positions would be the appropriate first line of offense.
We look for yields on Treasuries to remain low and for prices to remain in a range with volatility decreasing as time goes on. Therefore a strategy we look to implement would be to determine the probable trading range, then determine the best options to sell to collect premiums since premiums deteriorate as prices remain in a particular range creating the profit we seek. The range we project would be between 113-00 and 1200-00 in the September T-bond futures contract (see “Write outside the range”). Our strategy would be to sell puts as the price moves towards either our projected low and sell calls as prices move towards the projected high of the range. One must determine the viability for themselves as to which strike price to sell in order to gain 150-200 basis points. The closer to either end of our range requires an additional strategy of risk protection but produces the highest return. The use of vertical spreads, selling a nearby strike and buying a distant strike could affect a protective strategy but reduces the potential profit. At any time where the price moves close to the strike price the price appreciation would accelerate at a quicker pace then the protective option and would warrant covering both and creating a new sale and protective purchase. As prices remain in a narrow range, premiums will virtually collapse and the program would no longer be viable.
When will all this occur? When the markets finally fill the so called “exhaustion gap.” One first sign would be the climactic capitulation exemplified by extremely high volume and dramatic price move in a particular direction in an individual market. The second sign would be a reduced volume and narrow price range. Unfortunately that would lead to a prolonged flat market with contracting premiums on options and only sporadic forays beyond weak parameters.
