As regular readers of this blog you know that I have been watching the 89 level in TLT for quite a while and have commented on it in the past. I have done some more work on this and it is posted below. It is a bit longer than you are used to some please indulge me.

The trade:

Buy TBT on a breakout above 50 and SPY on a breakout above 110.50 and a breakdown of TLT through $89 in. Because these are highly liquid products and the trade is essentially a market bet a larger position can be taken. An equal dollar amount of each product should be put on.

Expected return: 7.50% on the SPY leg and 9% on the TBT leg. The SPY Price target is 120 and the TBT price target is 55. Partials can be taken at these levels and then the trade and stops should be reassessed. The SPY leg should be stopped out on any close below the 150 day MA (106.63) for a 3.5% loss and the TBT leg should be stopped out on any close below 48.50 (break of the 50 day MA) for a 3% loss.

Potential Risks: Risks to this trade are primarily flight to quality based. Also any meaningful change in the Fed’s stance articulated today’s FOMC minutes about looking to end quantitative easing would have a negative effect. A run to US Treasuries and out of equities would cause this trade to be unprofitable.

Expected Duration: Six to Eight weeks

Trade Thesis:

Since the market low in March 09 there have only been 2 meaningful pullbacks in the market a 9.48% correction (top to bottom) during the weeks of 6/5/09 and 7/10/09 and more recently a 9.17% correction from the weeks of 1/15/10 to 2/5/10.

Preceding both of those selloffs the etf TLT broke $89 (on the downside) but immediately snapped back and sell off in equities occurred. After the June/July selloff the SPY made it back to its previous high within two weeks. I believe we are in the second week of the recovery after the selloff.

Following the FOMC minutes today the TLT closed the day at 89.34 down 1.12% on the heavier than average volume.

It is my belief that the selloff in bonds came after a wave of fear had hit the market. The GM bankruptcy and issues regarding Fiat’s purchase of Chrysler were issues in June and fears over Greece et al were the problem more recently. A buy the rumor sell the news trade in the bond market if you will. Yields subsequently got pushed up to almost 4.8%. Equities were sold to buy bonds and hence the selloff.

In the Fed minutes today the Fed gave some tough talk on unwinding “quantitative easing”. The next two days bring PPI, jobless claims, leading indicators, the Philly Fed and CPI#’s. Benign numbers from those indicators coupled with some positive earnings will likely have the TLT break 89 on the downside again but this time I expect a rally in equities.

Why? A different kind of fear, this time we are coming off of an almost 10% correction in the SPY. That was not the case the last two times. Bulls want to buy the pull backs in this market now, the correction has come and gone and they have missed their chance. On top of that the Fed has signaled their desire to tighten and has sent a message of lower bond prices not higher. That was also not the case in the past.