Bonds Are Undervalued - How To Capitalized On It

I post my research on my subreddit: https://www.reddit.com/r/FinancialAnalysis/ This analysis is done based on TLT, which is the underlying index that TMF is based on. I'm only posting this as TMF because bonds do not move enough to make significant gains on their own. In reality I will be buying OTM call spreads on TLT.  Background The Federal Reserve announced that they will begin to raise interest rates in March of 2022. This is outlined here in their December report. https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20211215.pdf The main item to pay attention to is table one on page two. The bottom row shows expectations for the Federal Funds Rate (FFR) from 2021 through 2024 and beyond. The FFR is the rate that is classically being talked about when the topic is around the Fed raising or lowering interest rates. The FFR is currently sitting at 0.1% which is historically incredibly low. The last sequence of interest rate increases happened between late 2015 and the start of 2019 where it went from a familiar 0.1% up to approximately 2.4% at its peak. Look at table one again, you can see that the median long run FFR is 2.5% which mirrors the last sequence. Current Situation The Fed’s plan for 2022 paves the way for at least three interest rate hikes of 25 basis points each, with a potential fourth if the outlook worsens. This would leave the FFR somewhere between 0.85% and 1.1% with the median expected value being 0.9%. Futures can be used to gauge what the market thinks is going to happen in terms of expected bond prices. Here is an overview of what futures are expecting. https://www.cmegroup.com/insights/economic-research/2022/fed-rate-hikes-expectations-and-reality.html You might notice that the futures market is expecting rates to be around 1.3% in one years’ time, and 1.8% in two years’ time. I took these expectation graphs and added lines that show where the Fed claims the value should end up. That chart is better at illustrating the point but is behind on futures expectations. Here is a page that shows the expectations of futures and updates live. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html.This page is showing that somewhere around 1.6% interest rates are expected by the end of December of 2022 while the Fed maintains a 0.9% goal. People are often scared of going against the market. How can all of that money managed by people with nearly unlimited resources be so wrong? There are a variety of reasons, but I’m not sure they even matter. The point is that they are very often wrong. The market almost always over or under reacts compared to the Fed’s official policy. In this case there is an overreaction to the amount that interest rates will need to be raised. I think most of this is driven by misinformed ideas on inflation. I think the single most likely outcome of this is that the Fed sticks to its plan. There’s a significant number of people who think inflation is a massive problem and that the only way to deal with it is to crank up interest rates severely. Thankfully the Fed is run by people smarter than that. They are going to try to walk the line of increasing rates while keeping the economy from having a recession or the market from having a severe crash. Everything in this strategy outline requires that you believe: The most likely outcome is that the Fed sticks with their interest rate hiking plan Inflation is not going to cause surprise additional hikes beyond 4 for 2022 The market is often wrong when it comes to determining rate changes The market is factoring in too many rate hikes now Conclusion I’m not here to convince you to believe these things. These are the things I believe, and I am confident I can defend my beliefs, but that’s not the point. The point is that if all of these are true, bonds are severely undervalued. Bond prices go up when interest rates go down, and so when interest rates are expected to be high bond prices are expected to be low. However, if interest rates end up being lower than expected then it follows that bond prices will end up being higher than expected. This will require them to increase in price until the new expectations are met. I am not an expert in bond math and if anyone out there is, I would love your help in putting a number to this theory. How much could you expect a bond index like TLT to increase if there end up being 3 hikes instead of the expected 6?

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Bonds Are Undervalued - How To Capitalized On It

bullish

I post my research on my subreddit: https://www.reddit.com/r/FinancialAnalysis/

This analysis is done based on TLT, which is the underlying index that TMF is based on. I'm only posting this as TMF because bonds do not move enough to make significant gains on their own. In reality I will be buying OTM call spreads on TLT.

Background

The Federal Reserve announced that they will begin to raise interest rates in March of 2022. This is outlined here in their December report. https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20211215.pdf The main item to pay attention to is table one on page two.

The bottom row shows expectations for the Federal Funds Rate (FFR) from 2021 through 2024 and beyond. The FFR is the rate that is classically being talked about when the topic is around the Fed raising or lowering interest rates. The FFR is currently sitting at 0.1% which is historically incredibly low. The last sequence of interest rate increases happened between late 2015 and the start of 2019 where it went from a familiar 0.1% up to approximately 2.4% at its peak. Look at table one again, you can see that the median long run FFR is 2.5% which mirrors the last sequence.

Current Situation

The Fed's plan for 2022 paves the way for at least three interest rate hikes of 25 basis points each, with a potential fourth if the outlook worsens. This would leave the FFR somewhere between 0.85% and 1.1% with the median expected value being 0.9%. Futures can be used to gauge what the market thinks is going to happen in terms of expected bond prices. Here is an overview of what futures are expecting. https://www.cmegroup.com/insights/economic-research/2022/fed-rate-hikes-expectations-and-reality.html You might notice that the futures market is expecting rates to be around 1.3% in one years' time, and 1.8% in two years' time. I took these expectation graphs and added lines that show where the Fed claims the value should end up. That chart is better at illustrating the point but is behind on futures expectations. Here is a page that shows the expectations of futures and updates live. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html.This page is showing that somewhere around 1.6% interest rates are expected by the end of December of 2022 while the Fed maintains a 0.9% goal.

People are often scared of going against the market. How can all of that money managed by people with nearly unlimited resources be so wrong? There are a variety of reasons, but I'm not sure they even matter. The point is that they are very often wrong. The market almost always over or under reacts compared to the Fed's official policy. In this case there is an overreaction to the amount that interest rates will need to be raised. I think most of this is driven by misinformed ideas on inflation.

I think the single most likely outcome of this is that the Fed sticks to its plan. There's a significant number of people who think inflation is a massive problem and that the only way to deal with it is to crank up interest rates severely. Thankfully the Fed is run by people smarter than that. They are going to try to walk the line of increasing rates while keeping the economy from having a recession or the market from having a severe crash. Everything in this strategy outline requires that you believe:

  1. The most likely outcome is that the Fed sticks with their interest rate hiking plan

  2. Inflation is not going to cause surprise additional hikes beyond 4 for 2022

  3. The market is often wrong when it comes to determining rate changes

  4. The market is factoring in too many rate hikes now

Conclusion

I'm not here to convince you to believe these things. These are the things I believe, and I am confident I can defend my beliefs, but that's not the point. The point is that if all of these are true, bonds are severely undervalued. Bond prices go up when interest rates go down, and so when interest rates are expected to be high bond prices are expected to be low. However, if interest rates end up being lower than expected then it follows that bond prices will end up being higher than expected. This will require them to increase in price until the new expectations are met. I am not an expert in bond math and if anyone out there is, I would love your help in putting a number to this theory. How much could you expect a bond index like TLT to increase if there end up being 3 hikes instead of the expected 6?

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Confidence
6-12 Months
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