To The Moon

U.S. Treasury yields continued their retreat on Thursday, with the entire yield curve erasing the gains made after last Friday's nonfarm payroll report. The decline was particularly sharp in long-term yields.

The most attention-grabbing news on Thursday was Federal Reserve Governor Christopher Waller’s speech. Once a prominent hawk within the Fed, Waller now appears to have fully shifted to a dovish stance. He indicated that the Fed might cut rates three to four times this year and didn’t rule out a rate cut as early as March.

Market data shows that Waller’s comments led to a widespread overnight decline in Treasury yields across maturities. The 2-year yield fell 3.4 basis points to 4.238%, the 5-year yield dropped 4.8 basis points to 4.404%, the 10-year yield declined 3.9 basis points to 4.618%, and the 30-year yield slipped 2.3 basis points to 4.859%.

According to LSEG data, following Waller’s remarks, market expectations for the magnitude of rate cuts in 2025 rose from approximately 37 basis points late Wednesday to about 44 basis points. The market now sees a 69% chance of the next rate cut happening at the Fed’s June meeting. Before Waller’s speech, traders had anticipated a rate cut would occur sometime in the second half of the year.

Waller’s latest comments have clearly overturned many market participants' perception of his traditionally hawkish stance. On Thursday, Waller stated, "The inflation data we received on Wednesday was excellent. If future inflation data is as good as December's CPI, the Fed might cut rates more times than the market expects and earlier this year." He added that if similar data continues to emerge, there’s reason to believe rate cuts could arrive in the first half of the year. He even noted that he would not completely rule out a rate cut in March.

Waller also mentioned that the median estimate for the neutral rate among Fed officials implies the possibility of three to four rate cuts this year, depending on upcoming economic data. “This depends on the data. If it doesn’t align, the number of cuts could decrease to two, or if inflation remains stubborn, possibly just one.” After Waller's remarks, the 2-year Treasury yield, which is sensitive to monetary policy, fell to an intraday low of 4.25%. The market also grew more confident in the Fed’s December dot plot prediction of two rate cuts this year.

While Waller did not rule out a March rate cut, the probability priced into futures markets for such an event is still just 33%. Achieving this would likely require more supportive data and comments from other Fed officials.

Economic Data Impact

On the economic front, U.S. data released Thursday added to the downward pressure on Treasury yields. December retail sales growth fell short of expectations, and initial jobless claims were higher than anticipated. Retail sales rose 0.4% in December, below the expected 0.6%, though the previous two months' figures were revised upward. Initial jobless claims increased to 217,000 last week, reversing the decline from the prior week. Meanwhile, December import prices rose only slightly, marking the third consecutive month of increases, signaling a mild inflation outlook.

What Is a Diagonal Spread?

A diagonal spread is an options trading strategy that involves combining options with different strike prices and expiration dates. Typically, the long leg has a longer expiration date than the short leg. Diagonal spreads include both diagonal bull spreads and diagonal bear spreads.

Diagonal Bull Spread:

This strategy is similar to a bull call spread but takes it a step further by using options with different expiration dates. A trader buys a longer-dated call option with a lower strike price (long leg) and sells a shorter-dated call option with a higher strike price (short leg). The quantities of the long and short legs are the same.

TLT Diagonal Spread Example

Assume an investor is bullish on TLT over the next year. They could buy a call option with a $100 strike price expiring on June 30, 2025, for $65 (long leg).

Once the long leg is established, the investor can sell shorter-dated call options on a weekly basis as the short leg. For example, they could sell a call option with a $89 strike price expiring on January 24, earning a $14 premium.

• Profit Analysis:
  If the short call expires worthless, the investor would net a $13 profit ($14 premium minus $1 transaction cost). This represents approximately 20% of the $65 cost of the long call. With 164 days remaining on the long leg, the investor could potentially sell multiple short calls, significantly reducing or even offsetting the cost of the long call.

Benefits of Diagonal Spreads

1. Additional Income: Selling the short leg generates extra premium income, reducing the net cost of the long option.

2. Lower Breakeven Point: This income lowers the breakeven point of the strategy, increasing the probability of profit.

3. Flexibility: The strike price and expiration of the short leg can be adjusted, allowing for better risk management.

In essence, a diagonal spread is a cost-effective way to gain upside exposure and is a valuable strategy for investors to consider.