November 26th, 2008 

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Thin Bond trade and an early close ahead of Turkey Day.

The Treasury trading pits were open for a partial session on the Wednesday before Thanksgiving, but traders seemed to have opted out.  Reasonably so, traders weren't comfortable holding positions into the biggest travel day of the year and began offsetting trades on Tuesday and continued to do so today. In my opinion, it was this position squaring that led to the most recent four handle rally in the December 30 year bond. 

As I have been saying, hugely net short speculators took advantage of Monday's dip to reduce position size (by buying back futures or buying futures against short calls).  One thing that many may be unaware of is the dismal condition of the bond option market.  Last Thursday's spike left many short call option traders with deep in the money options and nobody willing to take the other side of their trade.  In other words, they couldn't offset their short options.  Instead, they were forced to buy futures contracts to eliminate intrinsic risk.   This forced futures buying added fuel to the fire and caused one of the biggest one day bond rallies on record.  For those with deep in the money short calls, conditions haven't gotten better.  From what I have been seeing, the typical bid/ask spread for some of the further in the money calls are as high as a full handle.  Thus, short option traders are being enticed to buy futures as opposed to buy their option back. 

The market is always right, but as you spend the holiday wondering how Treasury prices could have ever gotten to this level you may want to incorporate the artificial futures buying from short call holders and the snowballing effect of a massive short squeeze.  If our assumptions are correct, and a majority of the recent rally is based on factors mentioned in this newsletter we should be seeing a high in bonds and notes in the very near future.  Once the shorts are out, there may be nobody left to buy at such low yields.

I think that it is also fair to note that there has been some talk in regards to whether or not the U.S. government is partaking in activities similar to that used by the Bank of Japan earlier in the decade known as "Quantitative Easing" as a means of fighting deflation.  Quantitative easing involves maintaining interest rates as close to zero as possible and flooding commercial banks with excess liquidity through the massive purchase of government bonds.  This flood of liquidity should in theory add stimulus that exaggerates the effects of lower interest rates.  In a nutshell, the increased money supply is intended to lower long-term interest rates. 

I am not convinced that the U.S. government has adopted such a policy, but it does seem that market speculation as to whether they are now, or will in the future, has been enough to push long term rates to what seem to be ridiculous levels. 

I don't expect Treasuries to maintain lofty levels for long, but it is nearly impossible to predict how far this market can go before turning around.  I would prefer not to see it, but a retest of the highs may be underway.  I see resistance in the December long bond at 127'20 and again at 128'13.5. 

Buy note puts!  I like the January 10 year 115 puts, they are running about 15 ticks.

Treasury Bond and Note Option Trading Recommendations

**There is unlimited risk in naked option selling.

November 26 - Buy the January 10 year note 115 puts for about 15 ticks.

November 18 - I like selling the January 130 calls for 30 ticks or better, but slightly more aggressive traders may look at the129 calls for 30 (this was getting filled today). 

·         These are both well underwater, but we haven't given up on the long-term prospects.  We recommend holding on for now. 

November 20 - We were recommending to buy the December T- note 112 puts for about 19 ticks. 

·         November 24 - You can get in at a better price, you may want to buy the 113's. 

Treasury Bond and Note Futures Trading Recommendations

**There is unlimited risk in trading futures.

Flat

Eurodollar Futures Trading Recommendations

**There is unlimited risk in trading futures.

Flat

There is substantial risk of loss in trading futures and options.