Looking For The Security Of Treasuries? Buy Fives

For the past two and a half years the Five year treasury yield has ranged between 1.26% to 1.81% as shown below.  Consider buying FVH6 for a move back towards the lower end of this range.



On Tuesday the yield was 1.725, closer to the upper end of the range than the bottom.  Many analysts have said that treasury yields are ready to burst out to the upside as the Fed begins to hike.  However, much of the economic data has been downright bad, with many indicators revisiting levels not seen since 2009.  As an example, Manufacturing ISM released Monday was just 48.2 and the Prices Paid component was only 33.5, both at levels not seen since 2009.  The Atlanta Fed’s GDP Now forecast for Q4 was slashed from 1.3% to 0.7%. 

Not only is domestic data soft, the international backdrop remains challenging at best.  China continues to allow its currency to devalue, putting a deflationary pall on exports from Asia.  Oil is probing new lows.   Consider the competitive landscape closer to home.  One year ago the Canadian dollar was 1.1763, but closed yesterday at 1.3997; the dollar rallied nearly 19% vs the Loonie.  One year ago the Mexican peso was 14.9453.  Yesterday it closed 17.3493; the dollar rallied 16%.  In 2014 the US got about 27% of its imports from Canada and Mexico, imports which are now becoming cheaper and are pressuring domestic producers, (who have an increasing incentive to move production to neighboring countries).  The net effect is a wet blanket with respect to inflation.  And if the Fed has trouble hitting inflation targets, then the hiking campaign will fizzle. 

Given the environment, it seems reasonable to expect the five year yield to fall back toward the lower yield bound.  Halfway back of the recent yield move would put us around 1.5%.  The five year treasury future FVH6 closed Tuesday at 118-17.5.  The dollar value of a basis point on the contract is around $50.  Since a move of one full point in the contract (e.g. 118-17.0 to 119-17.0) is $1000, the yield will move approximately 20 bps per one futures point.  If we have a target of 1.50%, then FVH6 should trade around 119-24.  Consider buying FVH6 118.75/119.75 call spread for 19/64’s.  Max loss is 19/64 or $297, while max gain anywhere above 119-24 is 64/64 less 19/64 paid or 45/64’s, $703.

Learn more: Alex Manzara