Top-ticking interest rates

In the current environment, I see the biggest chance to make outsized returns as top-ticking interest rates through calls on TLT. It is obviously a high-risk play, as these things can go to zero if TLT simply goes nowhere long enough.

The question many are probably asking is why on earth would I expect long-dated interest rates to fall when central banks have been printing money leading to record-high inflation. I’ll focus my post on trying to explain, starting with this chart taken from @DereckCoatney on twitter:

Simply put, I don’t believe we’re at the bottom of the down-cycle yet in US treasury rates, and it largely has to do with debt levels being as high as they are. Take a look a this chart I put together with St Louis Fed data in Excel:

It’s a bit simplistic, and I believe all debt matters not just US debt, but you still see that interest rates bottomed as the debt/gdp ratio peaked after WW2 and that interest rates peaked as the debt/gdp ratio bottomed around 1981. Simply put, long end interest rates tend to follow growth – not CPI – and high debt levels are bad for growth.

Here’s another chart I put together a couple weeks ago to show that the US 10-year yield doesn’t seem to relate to CPI at all:

As for the federal reserve, I make my case here that a soft landing is never possible because hiking the federal funds rate doesn’t seem to have much effect on the CPI at all, they simply go up together until some highly levered fund blows up and the damage to the financial system causes a recession, after which both the CPI and fed fund’s rate plummet: https://johnonstocks.wordpress.com/2022/03/19/is-a-soft-landing-possible-i-argue-no/

We also have an environment where record fiscal and monetary stimulus is reversing. With federal spending plummeting in comparison to last year, while any wage gains have not been enough to offset hikes in necessities like food, fuel, and rent, a recession seems inevitable. See a more articulate argument by Dave Rosenberg and Stephanie Pomboy here: https://youtu.be/Ei6VJOwKTuE

It’s also important to note that outside of petroleum, US wholesale inventories have been climbing at record levels due to the bullwhip effect that Jeff Snider explains with fantastic charts here: https://alhambrapartners.com/2022/04/08/concocting-inventory/

So what about the massive QE? Isn’t that money printing going to show up somewhere?

In short, QE is not money printing. If anything it’s effect is the reverse, hence the lackluster response to Japan’s decade-plus of QE programs as well as the pre-pandemic QE programs adopted by the ECB and the FED after the great financial crisis.

QE is simply the federal reserve taking high quality interest-bearing collateral from it’s member banks and replacing them with a zero-paying bank reserve balance on their ledger. The banks can’t do anything with this reserve except transfer it to other member banks to balance their accounts. Alternatively, banks would be holding treasuries and/or US guaranteed mortgage-backed securities which would equally count as top-tier collateral, but also allow them to earn interest, conduct repurchase operations, or even sell these securities into the market.

Banks are not constrained by reserves, but by top-tier collateral. They can simply create loans by putting an asset on their balance sheet (a loan) and an equivalent liability on their balance sheet (a deposit). Before the great financial crisis, we had a massive increase in the money supply as financial complexity and the eurodollar system grew, but after 1980 the inflationary effects were increasingly masked by rampant globalization in which the world collected dollars as the US outsourced nearly all of their production. This is in large part why the middle class has been shrinking as real wages went nowhere while asset valuations continued to climb.

As the use of the US dollar grew well beyond the size of the US economy, demand for more dollar-equivalents remained high. Check out this 3-part Jeff Snider series for a more detailed interpretation: https://youtu.be/ABltMhCZIOg

In the period leading up to the great financial crisis in 2008, repo operations and cash equivalent collateral was growing in leaps and bounds as mortgage-backed securities of even low quality were sliced and hypothecated into extremely liquid, high quality, AAA collateral. Once the value of these was questioned, this collateral quickly lost its place in the repo market, and Bear Sterns was asked to suddenly produce a lot more collateral to back its loans. While this caused a lot of feedback requiring the Federal reserve and JP Morgan to coordinate the buyout/bailout and preserve the system, it fell out of control once the decision was made that Lehman Brothers should fail.

This chart is from the Eurodollar University episode I linked above, with my cursor showing the time stamp at 19:42.

Ever since 2008 ,we’ve had a number of problems show up in various parts of the system. The labor force participation rate began to annually decline, even among the working-age population. ZIRP (zero interest rate policy) became the norm in the US with negative rates in Europe and Japan, along with numberous QE programs, as repeated crises happened in a number of countries. The Federal Reserve sees markets as beasts to be lead by psychological means, trying to make all the economic data look rosy and equating QE with money printing in an attempt to encourage the “animal spirits” to come out and give us some kind of recovery and return to an elusive “normal”.

Essentially, I see a lot of false narratives out there –

from the excess supply of unfilled jobs in the highly unreliable JOLTS explained here: https://alhambrapartners.com/2022/01/05/before-nodding-along-w-fomcs-hawks-on-inflation-first-grab-yourself-a-beveridge/

to the money-printing narrative I argued against above.

Here are my latest asset allocations:

  • HEDGES (9.8%)
    • 9.8% TLT Calls
  • PRECIOUS METALS (38.9%)
    • 6.6% AG (Silver), calls
    • 4.4% EQX (Gold), calls
    • 2.3% EQX (Gold)
    • 4.1% SILV (Silver)
    • 4.0% SILVRF (Silver)
    • 3.2% LGDTF (Gold)
    • 2.9% MTA (Gold & Silver)
    • 2.6% MGMLF (Gold)
    • 2.7% RSNVF (Silver)
    • 2.2% SSVFF (Silver)
    • 2.2% HAMRF (Gold)
    • 0.9% MMNGF
    • 0.8% DSVSF (Silver)
  • URANIUM (22.0%)
    • 7.9% CCJ, shares w/ covered calls
    • 3.6% UUUU, shares w/ covered calls
    • 4.4% UEC, shares w/ covered calls
    • 2.1% BQSSF
    • 1.9% DNN
    • 1.6% ENCUF
    • 0.7% UROY
  • US CANNABIS (14.4%)
    • 1.8% AYRWF
    • 1.7% CCHWF
    • 1.7% CRLBF
    • 2.0% CURLF
    • 1.8% GTBIF
    • 1.7% TCNNF
    • 2.1% TRSSF
    • 1.7% VRNOF
  • BATTERY METALS (3.5%)
    • 2.0% NOVRF
    • 0.9% SBSW
    • 0.5% PGEZF
  • CRYPTO (1.0%)
    • 1.0% XRP
  • OTHER (1.6%)
    • 1.1% DOCN (cloud computing)
    • 0.5% OGZPY
    • 0.0% ATCO calls
  • CASH (8.9%)

I actually did a fair amount of buying this last week, as you can see by the reduced cash levels. I added a little bit to junior silver miner RSNVF, added some battery metals with more NOVRF then new positions in SBSW and MMNGF, and on Friday I added a significant plug of March 2023 TLT calls.

TLT has been absolutely crushed this week as the Fed endlessly talks about how much they’re going to need to raise rates this cycle and warning about how stocks will crash, so allocation stayed the same as I put in more money, yet I am up to 47 total TLT calls which is a lot of upside exposure.

In an environment like this where everyone is encouraged to dump bonds and buy puts, I can’t help but play contrarian. Contrarian plays like being long TLT can get you big moves, as everyone scrambles to re-balance, while consensus plays like being long AAPL and hedging with SPY puts can stop going up simply because there’s no one left to buy.

The Uranium sector is a bit different in that it is still a tiny valuation as a whole, so it can shoot up like Bitcoin when funds really start moving in. A significant portion of my remaining 22% stake may disappear next week as all my covered calls expire then, but I didn’t sell covered calls on everything so I’ll still have a stake, and the ones I did sell are just barely at-the-money even after this week’s gains. The reason I reduce like this is because I want to be able to add back when the Fed gets enough risk aversion to bring these miners back to key moving averages like the 50DMA and 200DMA.

I’ll end there. We’ve got some crazy months ahead, so keep a stoic view while trying to game these moves. Remember the famous words of Douglas Adams Hitchhiker’s Guide to the Galaxy: Don’t Panic.

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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2 Responses to Top-ticking interest rates

  1. JAG says:

    If QE is mechanically deflationary, does that mean QT is mechanically inflationary?

    A clarification on last week’s comment, I was suggesting to buy calls in the VIX index directly, not play volatility through an ETF.

  2. JAG says:

    [John said: In an environment like this where everyone is encouraged to dump bonds and buy puts, I can’t help but play contrarian. Contrarian plays like being long TLT can get you big moves…]

    I agree. TLT is looking more and more like a great contrarian play. I just wish it was a bit cheaper.

    Jason at Sentimentrader.com posted a chart of the Barclays Aggregate Bond Total Return Index vs Par Value (Sorry I don’t seem to be able to post the chart). It looks like the odds would be with you to be bullish on bonds right now.

    I bought a load of call options on HYG yesterday for 8 cents a piece. Now that is what I call cheap. The bipolar market mind absolutely hates HYG right now (even more than TLT, apparently). I’m betting the herd changes direction soon.

    Good luck to you on your trades.

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