Ready for a low-risk and low-return short that you probably won’t have to watch too closely, has low carrying costs, and has a built-in ceiling? As long as this time isn’t different I think now is a good time take a look at shorting intermediate treasury notes.
Unless you’ve been at a silent retreat with no access to the internet or the outside world for the past 75 days you’re well aware of what caused the 30+ year bull market in bonds to give one last hurrah before approaching the zero bound. As the chart above shows, treasury bonds spike up during the worst of the pandemic before settling into a yield range of 0.5 to 0.7 percent over the last 4 months.
For bond prices to go higher, interest rates would have to drop from the current ~0.6 percent to some lower level. It’s not impossible, but it’s not likely given the following:
- Results from monoclonal antibody studies later this summer or early Fall.
- Ongoing results from vaccine trials this Fall and Winter.
- Continued stimulus from Congress, whether it’s direct payments or infrastructure.
Since markets are forward-looking it’s more likely that interest rates will respond to the positive developments than continue to drop significantly.
Short Treasuries Risk vs Reward
But what happens if the positive developments don’t materialize, vaccine trials fail, and Congress refuses to act? What’s the downside to shorting intermediate Treasuries right here?
My assumption is that the Fed would defend the zero-bound floor. The zero-bound used to be financial dogma but since $11T in bonds are yielding less than 0 you have to acknowledge the chance that it won’t hold. I think you’ll see the Fed use more quantitative easing before they let rates drop below zero.
So assuming the lowest rates can go is zero then your downside loss on shorting Treasuries right now is a little more than 5 percent. If rates break the zero bound then I’d abandon the trade because our assumptions wouldn’t be true.
In addition to the downside case, if you hold intermediate Treasuries short you’re going to be paying ~0.6 percent per year in carry costs. Think: you could hold this trade for 10 years and only lose 6 percent if rates stay where they are. Or slightly less than 10 percent if rates go to zero by the end of those 10 years.
The flip side to this analysis is that no one is thinking rates will spike up anytime soon. There are always elements that think all this money printing by the FED will cause Weimer-like hyperinflation, but those same people say to buy gold for everything. At best, rates may creep up to 1 percent within 2 years. So if you short and hold treasuries you’re looking at a gain of ~7 percent over 2 years.
Not a great return, but for the risk profile and the fact it doesn’t cost you extra capital (besides margin requirements) it’s not a bad trade-off. Personally, I’d look to sell short whenever yields drop on a short-term basis then cover whenever they spike back up.
Rinse and repeat.