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How High Are Interest Rates Going?

05/31/2019 9:14 am EST

Focus: OPTIONS

Jay Soloff

Editor, Options Profit Engine

While not as sexy as other sectors, the interest rate market is making some noise, notes Jay Soloff.

If the markets weren’t so focused on the trade war with China, then most of the focus would likely be on interest rates. Of course, the trade war has an impact on interest rates, although it’s not a cut and dry connection. In a nutshell, tariffs could hurt domestic economic numbers, which could certainly factor into the Federal Reserve’s interest rate policy decisions.

Regardless, interest rates are impacted by a host of variables. Undoubtedly, the health of the economy is of prime importance. The Fed is looking at how fast the economy is growing (or shrinking) and how much (or how little) inflation there is. That means the market is also looking at those factors.

In terms of the relationship between interest rates and economic data, inflation and growth are mostly straightforward to comprehend. It’s when we start getting into the Treasury bond term structure where things really start to get complicated.

Is the Fed looking at the term structure for signals or are they ones setting the curve? The Fed sets the front-end of the curve, but the markets pretty much determine the rest. Also, how important is the shape of the Treasury yield curve in predicting recessions?

We are currently experiencing an inverted yield curve, something often cited as fool-proof recession indicator. Yet, the time from an inversion until a recession takes place is far from certain. Plus, in the era of an ultra-active Fed, is the Treasury term structure even meaningful?

There aren’t easy answers to these questions, which is why I look to the options markets for clues. Like anything else, interest rates and bond prices can be traded with options. There are options on futures or options on ETFs, which both can be effective vehicles for trading interest rates and bonds.

A very popular bond/interest rate instrument is iShares 20+ Year Treasury Bond ETF (TLT). TLT is a fund that tracks the price of long-term government bonds and tends to be the most active of the Treasury-related ETFs. Options are also heavily traded on the fund.

TLT moves up with the price of Treasury bonds, so it moves inversely to interest rates. The higher it goes; the lower interest rates are going. That being said, a large covered call trade this week in TLT suggests there may be a cap on how far interest rates are going to rise this summer.

More specifically, a trader purchased 500,000 shares of TLT at $128.66 while simultaneously selling 5,000 of the 130 calls expiring in August. That likely means this strategist doesn’t believe TLT is going much beyond $130 through mid-August (because the gains on the stock would be capped at that point).

What’s more, the calls were sold for $1.64, so $820,000 collected can be used as downside cushion against a drop in the price of TLT. This is essentially a neutral to moderately bullish trade. If TLT does nothing in the next few months the trader simply keeps that premium from the calls.

Assuming no stock movement, the yield on this trade is 1.3% over the life of the trade. The total return jumps to 2.3% if TLT closes at $130 or above at August expiration. That’s the max gain. It may not seem like much, but the yield on the call alone (1.3%) annualized would be 6.3% - not bad for a bond fund.

Plus, the trader is likely to collect another 78¢ in dividends over the period. That bumps the overall yield up to 1.9% or 9.2% annualized, not including any potential appreciation in the share price. In other words, for a conservative bet on rates not climbing much higher through August, the yield is pretty darn good.

TLT Chart

This is also a safe and easy trade you could make in your own account. A covered call like this one on TLT may not be that exciting, but it’s the sort of trade that will provide a stable yield without a lot of downside risk in the stock price.

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