Picture Perfect Trade Opportunity in US Treasuries: TLT and TBT

Trade idea from Landon Whaley: For those comfortable with shorting financial instruments, you could use the iShares Barclays 20+ Year Treasury Bond ETF (TLT). For “long-only” investors, consider using the ProShares UltraShort Barclays 20+ Year Treasury Bond ETF (TBT).

I chuckle every time I hear the phrase “animal spirits” because I immediately think of this quote: “An animal will jump at every sound, a leaf in the wind, a falling cone. A disciplined man will move only when it is necessary…the moment before it is necessary.”

This is one of my favorite quotes from The Ronin, a book loosely based on an ancient samurai legend told to the author, William Dale Jennings, by a Zen master.

I love this quote because it aptly describes the difference between what is required to be a successful investor and how most investors behave.

Last week, investors jumped at the latest “leaf in the wind:” the Trump allegations out of Washington. By being a disciplined man, I’m able to see the opportunities that are presented when twitchy investors are jumping at every sound.

Last week’s reflexive twitches have provided you and me with an opportunity to short long-dated US Treasuries.

Don’t Be an Animal, Be Disciplined
I’m human, and like the rest of you, I’m prone to flawed decisions. To minimize the adverse impact of my humanness on my investment decisions, I rely on my Gravitational Framework. This framework helps me contextualize what’s occurring in markets by helping me better understand the three most critical forces, or gravities, that impact asset prices: fundamental, quantitative and behavioral.

Fundamental Gravity Says What?
US growth has been accelerating since last June, when US GDP growth bottomed at 1.3%. As of Q1 2017, it is sitting at a 1.9% annual growth rate.

The early economic data from Q2 show this acceleration is continuing.

US industrial production in April accelerated to a 2.2% annual growth rate, up from 1.5% in March. This is the fourth consecutive monthly acceleration, and the fastest growth rate for industrial production in over two years. I could rattle off a half dozen other critical economic data points, but they all indicate one thing: half way through Q2, US growth continues to improve.

When you combine accelerating US growth with the Fed sticking to its course to normalize interest rates, you get a decidedly bearish Fundamental Gravity for long-dated US Treasuries.

Behavioral Gravity Says What?
The latest Commodity Futures Trading Commission data reveals that Treasury bulls are continuing to push their chips to the middle. Keep in mind that just two months ago, investors were historically short over 400K Treasury futures contracts. Now, because of a dramatic shift in investor perception of this market, bullish positioning is now the longest since 2007! Flip-flop anyone?

Being disciplined means I don’t flip-flop my bias for a market at every rustling leaf. I’ve carried a short bias for iShares 20+ Year Treasury Bond ETF (TLT) since December 5; that’s 25 consecutive weeks and counting.

The overly bullish positioning of investors in a market with a bearish Fundamental Gravity makes me salivate like Pavlov’s dogs. Did anyone hear a bell?

Quantitative Gravity Says What?
Although I track a number of quantitative factors, the one I want to discuss here is correlation.

For the uninitiated, “correlation” is simply one market’s relationship to another. A positive correlation means markets move together, and a negative correlation means the markets typically move in opposite directions.

For all markets I monitor, I track their correlation to both the US dollar and the US 10-year yield. With the Fed normalizing rates, these two markets are now even more meaningful.

While all cross-asset relationships are dynamic and prone to change, the long-dated US Treasury always maintains a negative relationship to US yields, for obvious reasons. On the other side of the coin, though there are periods of positive correlation, long-dated Treasuries typically maintain a negative relationship to the US dollar.

As long as the dollar trades above $96.40 and the 10-year yield on Treasuries remains above 2.163%, then long-dated Treasuries are going to have a very difficult time maintaining any upside momentum.

This relationship to yields and the greenback is why, after declining 18% from mid-July to mid-December, TLT has gained just 6% over the last five and half months. This is a classic bear market bounce, and 2% of that bounce came only last week when investors reacted to the latest leaf in the wind.

Trade Idea
For those of you who are comfortable with shorting financial instruments, you could use the iShares Barclays 20+ Year Treasury Bond ETF (TLT). You could initiate new short positions on rallies up to the $123.10 price level, or higher.

Depending on how much room to move you want to give this trade, you can use a risk price between $124.67 and $128.68. On the downside, I would book profits on some or all of the position on any decline down to the $120.57 to $119.61 range.

For those of you who are “long-only” investors, you could consider using the ProShares UltraShort Barclays 20+ Year Treasury Bond ETF (TBT).

A word of caution: TBT is both an inverse and a levered ETF, so please do your homework before buying this particular instrument. There are additional risks to using this ETF that you should consider before investing. However, if you want to proceed once your homework is done, then here is a potential plan.

You could initiate new long positions on a pullback to the $36.76 area, or lower. Depending on how much room to move you want to give this trade, you can use a risk price between $36.01 and $34.52. On the upside, I would book profits on some or all of the position on any rally up to the $38.55 to $39.92 range.

Bottom Line
Successful investing requires that you be disciplined. The only way I know to consistently make disciplined investment decisions is to be data dependent, process- driven and risk conscious. Stack the investment odds in your favor by rooting your every decision in a proven, time-tested process; acting on data, not narrative; and asking “what is my risk?” before “what is my profit potential?”