In a conversation with a trader friend of mine today, he casually noticed that the 10 and 30 year bond climbed as the equity/economy fear trade continued despite oil screaming to $140/barrel today. This price action goes directly at odds with the historical precedent we learned of falling long duration notes/bond prices and rampant commodity inflation. So I responded (paraphrasing myself more eloquently): 'One of these two markets is wrong. Either bonds fall here, with yields eventually running high to compensate for inflation trending up, or oil collapses signaling the beginning of a deflationary trend. A trade that makes sense is to sell bonds and sell crude here to some spread ratio where volatility and price movement matches.'

I came up with the ratio of 4 ZB (30 year bond futures) short to 1 CL, which represents a ratio of $460K (in bonds) to $140K (in Crude) notional dollars. Thats a 3.28 ratio, and considering an average of historic and implied volatility of crude is approximately 3 to 4 times that of the thirty year, this 3.28 ratio is somewhat accurate. Going short TLT 4-5x vs short 1x USO will do the same job.



The blue line is the performance of the spread. A reversal in crude or a Volcker-inspired policy track will make this a profitable trade. Until some catalyst, this trade will perform horribly if the broad equities market continues sliding while fear ascends. In the long term I do not believe this is sustainable. Looking at the chart on a long term historic basis is not useful, as this 4:1 ratio was not correct 5 or 10 years ago, as crude was trading at $15-30 in that time period nor did it pose the inflationary risk it does today. A correct ratio back then might have been 1 crude short to 1 30 year short as displayed in the green line below (for comparative purposes):



More interesting would be an analysis of the performance of this spread in Volcker years. Here of interest is the red line.