A ‘Sure’ Bet on Interest Rates

When designing an options trade, two of the main components are “if” and “when.” But when betting on interest rates, things become a little simpler, because there is no “if,” just a “when.” Interest rates have to go up since they can’t go any lower. So that just leaves the question of when.

I am in the double-dip recession camp. Before all is said and done, I think we will see 5-10 years of frustratingly low growth, and I do not believe interest rates will rise significantly in the coming years. But I do believe interest rates will rise in the next 12-18 months, and that the market will price this in six months in advance.

Here are my reasons:

1. Uncle Sam is set to issue several trillion dollars in new debt in the next two to three years. Right now, concerns over another meltdown have prompted people to run to the safe haven of Treasuries. But several trillion is a big number, and I believe some time in Q1 or Q2 of next year the market will begin to push up yields on Treasuries.

2. If there is even a whiff of inflation, bond yields will spike dramatically.

3. If there is even a whiff of a recovery, the Fed will signal the markets it sees a recovery by raising interest rates, trying to make the recovery emotionally self-sustaining.

4. As ultra-low interest rates continue to fail to spur the economy, it is clear the only beneficiary are the banks using the spread between Fed rates and market rates to generate profits and restore their balance sheets. The Fed cannot politically hold off traditional monetarists who see the risk of asset inflation outweighing the continuing benefit of low interest rates just to help out the banks.

5. Ultra-low interest rates have created far too much speculation in equity, bond and commodity markets, and the Fed may raise rates simply to flush out some speculators and put markets on notice they will do it again if necessary.

How to Play Rising Interest Rates

The riskiest and most profitable way to play rising yields and a decline in bond prices is to buy call options on the ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT). This exchange-traded fund is a double inverse ETF on the value of 20-year-plus Treasuries. When their daily value falls 1%, this ETF theoretically rises 2%. Because it tracks daily movements in bonds, it is more volatile than the long-term movement of the underlying bond.

If you like the idea underpinning the trade — interest rates will rise and the market will price this in six months or more before it happens — look at TBT January 2012 calls.

Why Should You Do This Now?�

* If you are bearish on the economy as I am, this is a hedge against your own judgments. If we are wrong, and this is recovery is real, this trade will serve to balance any losses from making bearish trades against the economy.

* If you take a long-term perspective — a position that expires in 2012 — this trade is built around easy-to-track fundamentals that give you time to add to or close the position.

* The risk in a longer-term trade is far lower than investing as a bear or a bull on equity markets, which can go anywhere, because over time, interest rates have to go up.

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