The Federal Reserve is accelerating its monetary tightening policies with inflation officially no longer ‘transitory,’ following Fed Chair Jerome Powell’s retirement of the term in regards to inflation in his Congressional testimony the first week of December. Yet, the US 10-Year yield is being held under 1.5%, when it should be trading much closer to 2%.

– Zacks

This is almost certainly due to a supply and demand imbalance in Treasuries as global investors rush to the safety of this “risk-free” bond as equities look shaky.

As the Fed pares back its $80 billion in monthly US Treasury purchases (making up roughly 50% of this market), a rare option trade with massive upside potential is manifesting itself. I’m looking at a 6-month put option trade that is ripe for the picking in iShares 7-10 Year T-Bond ETF IEF.

The Catalyst

The market’s preferred inflation gauge, the Consumer Price Index, just revealed the most significant annualized inflation jump since 1982 when Paul Volcker, the man who ended stagflation, headed up the Federal Reserve. In 1980, after several failed attempts to contain wild price jumps, Volcker was forced to ‘shock’ the market with a record high Fed Funds rate to control the US economy’s persistent inflation (known as the Volker shock).

Today, the Fed Funds rate sits at a record low, and investors are now worried that current Fed Chair Jerome Powell will be forced to implement a similar rate shock therapy to control swelling pricing pressures.

The focus will now be on the Fed meeting next week (December 14-15). Investors are anticipating it will conclude with an accelerated asset tapering program, putting the timeline to liftoff closer at hand. The Fed’s May meeting is the current consensus projection for the first Fed Funds rate-hike (aka liftoff), and the odds of at least 3 hikes (75 basis points) by the end of 2022 stand at nearly 70% and continues to rise.

The US 10-Year yield is poised to take off, and long-dated options are the perfect way to take advantage of this move.

The Trade

I am looking at a IEF June 17, 2022, put option with a $114 strike for $1.75 ($1.75 x 100 shares per contract = $175 per contract). I am utilizing puts on this ETF because bond prices are inversely correlated with yields. I chose that expiration because it allows us for the Fed’s May and June policy decisions to be priced into Treasuries before the put contract expires. The $114 strike we are using is just out of the money, has an exceptionally low implied volatility (IV) of 7%, and is comparatively more liquid than other contracts at this specific expiration (better volumes, relatively tight bid-ask, and decent open interest).

This long-term options trade is a no-brainer in this rising rate environment (almost too good to be true). Short interest in IEF is growing as investors see the potential profits in betting against Treasury bond prices, with inflation reaching a 39-year high in November.

I would enter this trade ASAP and look to exit once the 10-Year yield reaches 2%, which would generate a 130% return under the assumption that the 10-Year yield doesn’t get to 2% until June (which I see as extremely unlikely). In realty, the returns will likely be much higher because I presume that the IV of the option will rise as rates do, and the 10-Year will reach 2% prior to expiration, all having enriching implications on this put option’s premium (and in turn the returns).

Happy Trading!

Dan

Equity Strategist at Zacks Investment Research & editor of the Headline Trader Portfolio

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