The Fed may be getting ready to kick the can down the road.
It does not, in fact, appear as they are ready to make a jump back to QE quite yet.
However, with the bond volatility index (MOVE) up near the 150 area, leaders have hinted at using an exemption of the bank regulatory capital buffer to add liquidity to the bond market.
You may reca bank regulatory capital reform after the 2008 housing bubble burst …
A capital buffer to protect banks during market stress was initiated called the Supplementary Leverage Ratio (SLR). (Enthralling!)
SLR forces banks to hold around a 6% capital buffer against its on-balance sheet assets. It has strengthened balance sheets but at a cost of limited balance sheets applied to making markets in US Treasuries.
However, on Friday, Fed Gov. Michelle Bowman caught the attention of bond traders when she brought up Fed consideration of adjustments to the SLR …
This adjustment would have massive ramifications on US Treasuries versus corporate bonds.
Today we’ll look at a possible trade to execute this week.
Bank SLR Exemptions
An exemption for banks including US Treasuries in the SLR calculation would be a major benefit to the Treasury market.
Allowing banks to hold an unlimited amount of Treasuries on the balance sheet would be the same as the Fed announcing QE.
It would just give them cover from admitting they can’t stop inflation and would be similar to what the UK did two weeks ago to boost their bond market.
Asset prices and the US dollar would likely react as if the Fed was beginning QE itself. Stocks and bonds would rally and the dollar would correct downward.
I believe that outcome is inevitable, and given bond market dysfunction and accelerating economic weakness, that outcome is likely to come soon.
US Treasury Technicals
The technicals for the bond ETFs are looking supportive. There is a positively diverging lower low developing …
Notice the chart below iShares Treasury Bond 7-10yr maturity ETF (IEF). I am looking for an opportunity to buy a low risk high reward call spread.
A call spread will keep the volatility impact in check and provide some nice upside surprise if the Fed does lean that way.
The risk reward is very much swayed towards a correction higher in price right now …
This week the Treasury is issuing new bond supply totaling $92 billion in size, so traders will be setting up shorts in the auctions.
An IEF Oct. 21 95/95 call spread offers a decent risk/reward into the Oct. 21 expiry.
The spread was priced yesterday at around $60, with a chance for a maximum payout of $200 for a potential gain of 233%.
Bring It Home
I also like the trade as an addition to the Power Income Trader portfolio, which has bearish strategies on high yield bonds (HYG), the British Pound (FXB) and also the Russell 2000 ETF (IWN) ….
An IEF bull strategy would hedge those positions, while outperforming them in a big way if the Fed did hint at an exemption for banks against holding US Treasury bonds.
I never like being in crowded trades and, obviously after last week, the short stock and bond trade is getting a bit crowded.
Stay tuned for more on this as we should see significant volatility this week.
In the meantime …
Live and Trade With passion My Friend,
Griff