By: Steve Smith
The recent break of the stock market’s uninterrupted rally, and the recent volatility can both be tied to a rapid rise in interest rates. This increase has followed strong economic data and hawkish comments from the Federal Reserve. As we’re about to see, this provides an interesting opportunity for options trading.
The combination of Federal Reserve’s intention to make three additional rate hikes this year with incipient signs of inflation caused yield on the 10-Year Note to jump some 35 basis points in the past three weeks, the quickest jump and to the highest level in over 18 months. And many think rates are heading still higher and that could ultimately put an end to the bull market.
The weight of higher interest rates comes in three places. First, higher yielding bonds will compete for investment dollars, especially from people heading into retirement. Second, stock valuation will become more expensive on a discounted cash flow model. And finally, higher rates will also choke off capital available to corporations.
The consensus magic number to trigger some or all of the above seems to be a 3 percent yield on the 10 Year-Note.
During the recent stock decline, 10-year bonds hit a high of 2.98%. Whew, that was close.
But data on how traders, both institutional and individual, shows people are betting on rates continuing to rise, as the amount of ‘short’ bond positions has hit its highest point in over a decade.
In the near term, I think those shorts will be proved wrong, as I expect yields to drop back to the 2.75% level over the next month or two.
My reasoning rest on these items:
- The bond market is global and right now other Central Banks, especially both European ECB and Japan’s BOJ, are keeping short-term rates at or below zero. This will anchor the U.S. market preventing it from rising much further.
- The short positioning in bonds is being done mostly by speculators such as hedge funds. As such it can be taken as a contrary indicator.
Actors that would need to lock in income, such as pension funds, have already shown that the 2.80%-2.90% is attractive and have ramped up purchases in the past week.
According to a commitment of traders report, the net bullish wagers by asset managers, such as insurance companies, on 10-year Treasury note futures rose to 441,822 contracts in the week ending Feb. 13. Net bearish wagers from leveraged funds, including hedge funds and commodity trading advisers, rose to 310,669 contracts.
Hedge-fund positioning can serve as a contrarian indicator, as crowded bets by speculators on the bond market often precede painful reversals. In January 2017, Jay Barry, an interest-rate strategist at J.P. Morgan, estimated that more than 75% of the time when hedge funds rushed into wagers that yields would travel one way, rates would end up moving in the opposite direction in the following month.
That’s partly because institutional investors dwarf their smaller-yet-nimble counterparts in the hedge-fund world. When cash from pension funds and other institutions begins to flow, momentum can turn swiftly against the speculator crowd.
- The Fed is already walking back from their path of four more rate hikes. After seeing the markets response to last week’s FOMC minutes Louis Fed President James Bullard did multiple interviews basically saying it would be wrong for the Fed to hike rates aggressively, if at all.
- Technical analysis or the chart. I use the iShares Bond Exchange Trade Fund, ticker TLT, as my trading proxy for the 10-year, and it has major support at the $116.50 level which essentially aligns with a 3% yield.
Longer term this level will probably break, but right now it offers a great risk/reward entry point for getting long.
The trade I’m making to establish a bullish position in TLT is straightforward purchase of call options. Specifically, the April Call with a 118 strike for $2.00 per contract.
My target is for shares of TLT to be at $122, or equivalent of a 2.75% yield, which is also resistance as indicated on the chart above.
This would give the calls a minimum value of $4 for 100% gain over the two month holding period.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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