Trade U.S. Treasuries with Diagonal Spreads as Fed eyes rate cuts

After the August CPI report, Nick Timiraos, known as the Fed’s "mouthpiece," wrote that the inflation rate dropped to a three-year low in August. This decrease might prompt the Fed to start gradually cutting rates at next week’s meeting.

According to the Labor Department, August’s CPI rose by 2.5% year-over-year, down from 2.9% in July, marking the fifth consecutive month of cooling. Core CPI, which excludes volatile food and energy costs, remained steady at 3.2%.

Despite a stronger-than-expected housing inflation in August, which could complicate a larger 50-basis-point cut, traders are betting on a more gradual policy easing by the Fed.

Most Fed officials have signaled they’re ready to cut rates, and the CPI report isn’t expected to change that. This inflation relief offers some breathing room for cost-strapped households, even as the labor market cools with slower hiring and wage growth.

As the rate cut cycle becomes certain, the best strategy to go long on $iShares 20+ Year Treasury Bond ETF(TLT)$ is the Diagonal Spread.

What is a Diagonal Spread?

A diagonal spread involves using options with different strike prices and expiration dates to create a spread. Typically, the long position has a longer duration than the short one. Diagonal spreads include diagonal bull spreads and diagonal bear spreads.

A diagonal bull spread is similar to a bull call spread but with an upgrade. The difference is that the two options in a diagonal spread have different expiration dates. You buy a long call options with a lower strike price and sells a short call options with a higher strike price, with the same number of calls bought and sold.

TLT Diagonal Spread Example

Let’s say you’re bullish on the iShares 20+ Year Treasury Bond ETF for the next year or more. You could buy a call option with a $100 strike price expiring on June 30, 2025. This call becomes your long call, and it would cost you $600 at the latest price.

Once the long call is established, you can set up a short call with a shorter expiration period. For instance, you might sell a $103 strike price call option expiring on September 18. You’d collect a premium of $13 for this option.

If the sold call isn’t exercised, you make a $13 profit, which is about 2.16% relative to the $600 cost of the long call. However, because you can sell short calls weekly, you could potentially repeat this process numerous times over the 292 days remaining on the long call. Each successful sale of a call option further offsets the cost of the long call, potentially even making it free.

Compared to buying a call outright, the diagonal spread strategy not only reduces your net premium expenditure but also shifts the break-even point lower, improving your win rate.

The flexibility of the short call’s strike prices and expiration dates allows you to adjust your risk exposure. This makes the diagonal spread a cost-effective way to buy call options and is especially well-suited for treasury bond investments.