Bet on a Fed Cut by Betting Against Two ETFs

Assuming that the Fed is going to cut interest rates at or before the Sept. 18 meeting (and the futures markets are pricing in a high probability of that occurring), it makes sense to look to profit from the regime change. Shorting exchange-traded funds that represent longer-dated Treasuries is one way to do so.

The chart below of the five-year Treasury yield shows how the yield has plummeted from above 5% down to 4.25%.

Expectations for both economic growth and inflation have fallen hard. But one of the effects of a new rate-cutting regime is likely to be that expectations for both economic growth and inflation will begin to rise again, which should push bond yields higher (and prices lower).

Source: TheAgileTrader

One of the effects of the recent subprime market problems has been a flight to quality, especially a rush into Treasuries. And that flight to quality has pushed the prices of those Treasuries higher, dropping their yields down below what might otherwise be considered fair value.

So, we have two reasons to look for a reversal in bonds. Fundamentally, both growth and inflation expectations should rise. Once that happens, we should see the flight to quality reverse, pushing money out of bonds and into risk assets.

We can see the footprints of the flight to quality in the price momentum of the iShares Lehman 7-10 Yr Treasury Bond Fund (IEF - commentary - Cramer's Take).

Source: TheAgileTrader

IEF has shot up in price from about $79.59 to $83.74 since mid-June. And as the yellow highlights indicate, when the three-month rate of change gets this stretched to the upside (up more than 5%), there is a marked tendency for IEF to pull back significantly.

Likewise with the iShares Lehman 20-Yr Treasury Bond Fund (TLT - commentary - Cramer's Take).

Source: TheAgileTrader

Over roughly the past three months, TLT is up better than 7%. The yellow highlights on this chart show where momentum previously has been stretched this far. There's a strong tendency for these yellow highlights to be associated with local tops in TLT.

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At the time of publication, Oliensis was short long-dated Treasury futures, although positions may change at any time.

Adam Oliensis is president of Dog Dreams Unlimited, a guaranteed introducing futures brokerage, and editor of the trading service The Agile Trader. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Oliensis appreciates your feedback; click here to send him an email.