Mar

19

I am thinking about a trade. The Federal Reserve has driven short-term interest rates down. Investor fear of what's to come has pushed long-term (10yr) bond yields down as well. But Fed's actions are inflationary in the long run. Thus at some point inflation will pick up and this should drive long-term bonds lower. I cannot short stocks or bonds in my client portfolios thus I was thinking about buying either a mutual fund or an ETF that is shorts or has inverse position (through futures) of US Treasuries. My thinking is as follows if you assume a duration of 10 year bond is roughly 7 years, then my downside that the rates decline from 3.3% (an all time low) to 2.3% is about 7%. My total downside risk if rates go down to 0% is 23.1% (7% x 3.3). This is more of a mathematical downside, but not a real downside. The upside: depending on how much infaltion the Fed's actions create, inflation may run higher than we observed in the recent past, rates may rise to let's say 6%, let's make it 6.3% to keep the math simple. The upside is 21% (3 x 7%). Here I am ignoring a management fee that a fund company charges, but at the same time if, I understand this right, there is no cost of carry. The bottom line: if you assign probabilities of interest rates going down, doing nothing or going up, the expected return looks good.


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