Answer: Not very much, but the market reacted anyway.
The Fed Chairman testified before the Joint Economic Committee of Congress today in Washington, and the message was the same as before: If the economic data indicate a sustained labor market recovery, the Fed may step down asset purchases after the next few Fed meetings. Bernanke emphasized, however, that ending QE3 prematurely would endanger the recovery. The Fed is going to let the data dictate their actions, which is what Bernanke and the Fed governors have been saying all along.
The market, however, interpreted this as a higher likelihood of QE3 ending sooner than anticipated, and interest rates soared. The 10-year yield jumped 11bps today, from 1.93% to 2.04%:
Although I believe that yields will move substantially higher over the next few years (remember, the blog’s called “Higher Yield”), I think the market is oversold in the short term. We’ve had a big run-up in yields over the last three weeks, about 40bps on the 10-year Treasury:
If the weekly initial unemployment claims disappoint tomorrow morning, I’d expect a big drop in yields. As readers of this blog know, on a monthly basis I’m focused on the weekly continuing claims as a predictor of the monthly new jobs number. But initial claims are a stronger driver of short-term yield movements, since they’re the focus of most market participants. The forecast (according to Bloomberg) is for initial jobless claims of 345K. If we get an initial claims number 350K or above, I think there will be a rally in bonds and a drop in yields.
How to trade this? One could buy treasuries or treasury futures, but purchasing calls on treasury futures looks more interesting. A risky play is the USM3 (June treasury bond futures) calls with strike 144 that expire Friday. With the underlying security (USM3) at 142 17/32, the last trade in these calls was 5/64. The 10-year yield would have to fall about 12bps or so for the treasury future (USM3) to rise to 144 and then the option would be just at the money. If that happens (say, if the initial claims come in at 360K), I estimate the call will trade around 25/64 or 30/64, a nice gain. However, if the initial claims are reasonable or good, say below 350K, yields will stay the same or rise, the price of the calls will drop, and it may be tough selling out of the position for a price greater than 1/64 or 2/64, meaning a 60% or 80% loss.
A less risky trade is buying USU3 (September treasury bond futures) calls that expire June 21. The 145 calls are trading about 28/64, and a big drop from yesterday’s close of 50/64. If yields come back down to where they closed yesterday on a bad initial claims number, it’s reasonable to assume these calls will revert (near) to yesterday’s price of 50/64 – the loss in time-value from being closer to expiry will be (roughly) cancelled out by the increase in volatility. If yields stay where they are after the claims announcement, I wouldn’t expect the option price to change much. But if we get a great jobs number, say 315K or better, yields may continue their march upward, and these calls could also lose a large chunk of their value.
PLEASE NOTE: Nothing in this blog post or other blog posts should be taken as trade recommendations or advice, and you should not invest based on anything you read in this blog. Every investor’s situation is different, and specific trade ideas are never appropriate for every individual investor.