After the official rate of inflation topped 7%, Federal Reserve officials acknowledged they need to do something. Interest rates are finally going up.I live in the real world. The world where I longingly say, “I remember when gas was $0.50 a gallon” as I spend almost $100 to fill the tank.Thanks to this memory, I saw inflation coming months ago and started planning for rate hikes — the Fed’s trusty solution to runaway inflation. Unfortunately, the Fed dithered, failing to act quick enough. Now we face even higher prices.You might recall that when I first introduced this idea, I recommended a trade that would take advantage of falling bond prices as the Fed gradually raised interest rates. I’ve received a couple emails from readers asking for an update on this trade — which is a bit down since my recommendation.Today, I’ll give that update. And I’ll tell you why I’m more convinced than ever that this trade is a winner.
To combat inflation, the Fed is planning three rate hikes this year. Futures markets are pricing in a 66.8% probability of at least four rate hikes before the end of 2022.Since at least the 1980s, the Fed has followed the lead of the market. That tells me we should expect a big move from the Fed in the next few months.Long-term bonds are the best way to trade interest rates for us individual investors. That’s because we get more bang for the buck. A 1% change in interest rates could move the price of a long bond by 10% or more. Short-term bills are expected to change by less than 2%.Options on long bonds are the best way to gain significant exposure to this trade with limited risk.That’s why, in June, I recommended put options on the iShares 20+ Year Treasury Bond ETF (TLT). My trade thesis hasn’t changed so I won’t repeat the details now. (You can read it here.)
Checking in on TLT
TLT is now trading at about $140. A put option expiring on January 23, 2023, with an exercise price of $145 is trading for about $12.50. That’s down from about $15 when I originally recommended the trade.Buying this put option gives you the right to sell TLT for $145 per share by January 23, 2023. For that right you pay a $12.50 premium — or, as each option contract controls 100 shares of stock, $1,250 per contract.The further TLT falls, the more profitable this put option becomes.
I continue to expect a spike in interest rates and see the yield on the 10-year Treasury note at least doubling this year. That could result in a 30% decline in TLT. At $101, the put option would be worth about $44.Interest rates could go even higher in the short run. Inflation is likely to remain elevated and could be above 8% before the end of the summer.It should continue drifting higher for the next few months solely because of the way it’s calculated. Home price gains take months to be fully reflected in the data based on the formulas the government uses.As inflation persists, rhetoric rather than action from government officials will lead to a realization that no one can stop inflation. Higher expectations are a self-fulfilling prophecy in the short run.I believe this is the ideal way to trade higher interest rates. It also benefits from a lack of faith in effective government policies — another trend that’s been rising in recent months.Regards,
Chart of the Day:Small-Cap Breakdown
(Click here to view larger image.)
Well, well, if it isn’t small caps making me look bad.In 2022 so far, I’ve been bullish on small caps. So have Chad and Amber — pointing to the rate hikes from the Fed as a good thing for markets, even if we may see some pain upfront.Most investors seem to disagree. The iShares Russell 2000 ETF (IWM) broke down out of its long trading range this week, bringing about the lowest prices for the index in almost exactly a year.Yet at the same time, we’re still seeing that bullish divergence on the daily chart. The momentum indicators are making lower highs while the price makes fresh lows.I’m fully prepared for egg to land on my face here. But I doubt we’re starting to see a major crash in small caps or in stocks across the board. What we’re seeing are simple jitters ahead of a much-needed withdrawal of stimulus.What’s more likely, in my view, is a major bounce that sends small caps back into the range, and ultimately up and out of it in 2022.Regards,
