To The Moon

Former U.S. Treasury Secretary Lawrence Summers said on Thursday that the Federal Reserve's decision to significantly slow down the pace of shrinking balance sheet this week actually sent a worrying signal that there is a problem with market demand for long-term federal debt.

"This should arouse people's alarm and be regarded as a disturbing trend," Summers said in an interview on TV program. He pointed to the move as a sign that Fed policymakers believe that "the market absorption capacity of long-term bonds is limited."

The Federal Reserve announced on Wednesday that it will lower the upper limit on the amount of U.S. Treasury Bond that will not be reinvested after maturity from $25 billion per month to $5 billion starting in April. While Powell said the immediate trigger for policymakers to discuss the issue was the complexity of the federal debt ceiling, the decision also reflected a broader discussion on what constitutes the appropriate pace for a quantitative tightening (QT) program.

To the surprise of some observers, Powell did not hint at a renewed pace of quantitative tightening after Congress resolves the debt ceiling issue, expected later this year.

Summers, who is currently a professor at Harvard University, said the slowdown in quantitative tightening has even occurred after a decline in long-term Treasury Bond yields. The benchmark 10-year Treasury Bond yield is currently around 4.23%, down significantly from 4.81% in mid-January.

Slowing QT also has the effect of shortening the overall maturity of U.S. public sector debt, as bank reserves are created when the Fed buys Treasury Bond (which pay interest at overnight rates). Summers said, "We found that in order to borrow, it was necessary to shorten the maturity structure of government debt."

He noted that the Fed may be concerned about a situation similar to what happened in the UK in September 2022, when the government of former British Prime Minister Truss triggered a crisis over an unfunded tax cut plan. The Bank of England had to intervene in the bond market to avoid a collapse.

"This is the Fed's policy to curb possible'Truss-style risks'-the kind of unexpected events that happen in the UK," Summers said. "It also reflects almost everything we hear about fiscal policy. Policy movements are deteriorating, not improving."

What is a diagonal spread?

diagonal spread refers to the spread established using options with different strike prices and different expiration dates. Generally, the duration of the long leg in the spread is longer than that of the short leg. Diagonal spreads include diagonal bull spreads versus diagonal bear spreads.

The diagonal bull spread is basically similar to the bull subscription spread strategy, except that it has been upgraded and improved again.The difference is that the two options for the diagonal spread have different expirations, the trader buys a longer-term call option with a lower strike price and sells a shorter-term call option with a higher strike price. The number of call options bought and sold is still the same.

TLT Diagonal Spread Case

Assuming investors are bullish for the next yearTLT, you can directly buy the call option with an exercise price of 92 and an expiration date of January 16, 2026. This option becomes our long leg, which costs $520 at the latest transaction price.

After the long leg is established, we can establish the short leg according to a shorter cycle than the long leg. Here, we can choose to establish it on a weekly basis. Choose to sell a call option with a strike price of $93 and an expiration date of March 28 and receive premium of $13.

Here, if the call option sold is not exercised, it will generate a profit of $13, which is about 2.5% relative to the cost of $520 on the long side. However, the short leg can be executed once a week. With the remaining date of the long leg of 301 days, investors can sell call options many times. If some sold call options can successfully obtain premium, the cost of buying call options will be greatly reduced. The cost of the option itself, and even get call options for free.

Compared with buying bulls alone, the diagonal spread obtains an additional premium income, which reduces the overall net premium expenditure of the strategy, and the break-even point of the strategy is also shifted to the left, and the winning rate is also increased accordingly. AdditionallyThe selling point of the diagonal spread can be controlled by investors themselves, so different short-selling efforts can be selected in different cycles to facilitate investors to control risks. Diagonal spreadEssentially, it is a low-cost call option strategy that is worth investors studying.