On the Way to Trading Inflation, Don’t Forget Credit Spreads

• Posted by Greg Harmon
• on April 25th, 2011

Everybody but the Bernank sees inflation rising. And now he is even saying that it may be coming. Among bond traders this of course leads to debates on how best to trade the scenario. Short long term Treasuries? Put on a curve trade? Inflation swaps? Sell Treasury Futures? For those in the equity market the choice has been to either buy the ProShares Ultra Short 20+ Year Treasury ETF(ticker: $TBT) or short the iShares Barclays 20+ Year Treasury ETF (ticker:$TLT). But with rising yields there are trades to consider along the credit curve as well that can be quite lucrative.

Below are three that are setting up from the same chart pattern in the ratio charts between credit sector ETFs. The 3 charts below show the potential for a Head and Shoulders top formation with a slightly rising neck line. The Relative Strength Index (RSI) for the ratios has retraced back to the mid line and is poised to break through lower. The Moving Average Convergence Divergence (MACD) for each ratio is either waning or about to cross negative. The ratio is below the falling 100 and 200 day Simple Moving Averages (SMA) and sitting at or on support of the 20 and 50 day SMA’s. If the ratio falls through the 20 and 50 SMA support then just the potential neckline of the Head and Shoulders remains as support before a potentially large move downward. These all imply that if Treasury yields are rising that Investment Grade and High Yield debt spreads will actually tighten. Let’s look at the specifics.

TLT vs LQD, Treasuries vs Investment Grade Corporates

The chart above of the TLT against the iShares iBoxx Investment Grade Corp Bond ETF (ticker:$LQD) has the potential neckline in blue. A break of the neckline has a Head and Shoulders target of that is at least 4.6% below the current ratio. With 20 year Treasuries at 4% and Investment grade yields at 4.59% according to Bloomberg, this would mean a tightening of the spread by nearly 35 basis points (assumes initially a 20 year Treasury priced at par yielding 4% moves 4.6% in price). The economics of the ETF trade placed Monday would be $517 – $719 if you were short 100 shares of TLT and long 100 shares of LQD at the target.

LQD vs JNK, Investment Grade Corporates vs. High Yield

The chart of LQD against SPDR Barclays Capital High Yield Bind ETF (ticker:$JNK) above has a target of 2.54 on the ratio on a break of the neckline at 2.67, or a 4.9% move. With High Yield rates at 7.78% according to Bloomberg and using the 4.59% Investment grade yield from above, this would create a tightening of over 39 bp assuming the Investment grade bond makes the full move. The economics of the ETF trade placed Monday would be $602 – $616 if you were short 100 shares of LQD and long 260 shares of JNK at the target.

TLT vs JNK, Treasuries vs High Yield

Finally the chart of TLT against JNK above has a target of 2.03 on the ratio on a break of the neckline at 2.22, or a 8.6% move. Using the rates above and assuming the full move from the Treasuries then this is a 67bp tightening in the spread. The economics of this ETF trade placed Monday would be $996 – $1,079 if you were short 100 shares of TLT and long 220 shares of JNK at the target.

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