Wednesday, August 25, 2010

One guaranteed relative value trade




It is hard to make a sure winning trade in this unusually uncertain economy. However, there is one trade I perceive as a high confidence level trade. If you are conservative in nature and don't want to take equity market risk -- long or short, or you are too busy and don't have the time to take care of your investment portfolios, then this trade should work in your favour over the long term.

The above chart shows the 2s10s curve, which is the spread between 10 year Treasury yield and 2 year Treasury yield. 2s10s Treasury yield curve is a barometer of the economy, it peaks and troughs with each business cycle. In the current cycle, it topped out at 290 level in the beginning of 2010. Since then, it trended down to the trend line and broke it decisively later on. I believe this curve will tightened more in the near future. 2 year yield is around 50bps, even with Fed on hold, the room for downside is very limited. However, 10 year yield  is at 2.50%, with the possible downward revision to GDP growth, subdued core inflation and the speed of flight to safety, it can shoot for 2.00% or even lower. This alone will flatten the curve massively. Meanwhile, when the Fed decide to hike, it will act in a very aggressive fashion, given how much liquidity it punch into the system. This will lift the front end of the curve abruptly, which is beneficial to our flattening trade.

The initial target comes in at 173bps, the 38.2% Fibonacci retracement, then at 136bps, the 50% Fibonacci retracement and then at 99bps, the 61.8% Fibonacci retracement.

For retail investors to take position based on the view expressed above, you can short SHY (1-3 year Treasury bond) and long IEF (7-10 year Treasury bond). SHY is the orange line in the chart and IEF is the white line. Hold it for some period of time, you will see your account goes up faster than GDP growth, and that's for sure with little attention.

3 comments:

Sightr said...

Thanks.

liz said...

顺便说一句,今天让我有种大家纷纷抢便宜货的感觉。其实昨天的报告已把今天的报告account for了,导致mkt有点 over sold. 但即使这样,tech昨天就蠢蠢欲动,今天最终引领局势。感觉如果明天unemployment数据好的话,明天上涨势头会很大。

liz said...

blow it! USD/EUR pared the news. Now everyone is holding cash...

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