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The Treasury Paradox

There's been a lot of noise out there.

On the back of the downgrade and some potential ECB news, we now have all the "known-knowns."

Except for price.

US Treasuries are certainly going to be an interesting play over the next few weeks, and it's important to understand some of the macro interplay that will take place in the near term.

The Supply Side

We don't really know how the downgrade is going to affect the US Treasury market. We would assume that since there's more "risk" in the market as a result of the S&P news, then there will have to be more "reward" in order to entice investors.

On top of that, many firms have strict requirements with respect to what kind of securities they can hold, and they often use rating companies to help determine their risk profile. There may be some liquidations or increases in margin requirements that could structurally change the market.

That means rates should rise to bring in more demand, which means $TLT should drop lower.

The Demand Side

But here's where it gets interesting.

Let's say rates rise, which means it costs more for the US Treasury to finance current expenditures. That means spending cuts, and if the government pulls out, that means expectations of growth could slow. It's possible we get sucked into the deflationary vortex that hits commodities, equities, and the risk-on trade in general.

And when we see growth slow, that means the expectations of inflation go away, and rates will go lower. In other words, treasuries can stay bid on the back of this news.

This is what's known as a "negative feedback loop," in which price can moderate between two extreme forces of supply and demand.

Will this relationship always be there? So far. This macro interplay has been present in the bond market for quite a while now. Of course we could break and everyone flees to $GLD, but that's another story.

This week I'm watching $TLT $TBT and $TNX as possible tells.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/