Long term treasury bonds have been in a bear market since 2020 as you can see in the chart of ZROZ below.
But now that inflation has been tamed, according to the first narrative, a new bull market is about to begin. Interest rates are about to be reduced and a recession has been avoided. And if low inflation is a sign of a recession, even better. Treasuries will once more become the safe haven.
A continuation of a bear market rally in treasuries could trigger an unwinding of a massive carry trade. Many funds sold treasuries short to buy junk bonds that pay a much higher interest rate. In a recession treasuries would be considered a safe haven while junk bonds are expected to occasionally default. If that happens the recent bear market rally could become violent.
But according to a second narrative, if short term interest rates are reduced with no recession, the U.S. dollar would depreciate, inflation would return and long term treasuries would continue their bear decline. Therefore, the best play is a “steepener”. Buying short term treasuries while selling long term treasuries short.
Buying short term treasuries is a no brainer under all of these scenarios. But the risk reward ratio of being short of long term treasuries at this point doesn’t look favorable.
To me it seems that these scenarios could both be true. First, disinflation and a bear market rally in treasuries. Second, a violent rally as the short treasury carry trade is unwound, crashing junk bonds and then stocks. Third, a recession and a reduction of short term interest rates. Fourth, dollar depreciation, the return of growth, inflation, and a continuation of the bear market in long term treasuries.
And using options, one could construct a trade with exposure to both scenarios with no carry cost.
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