Today’s themes – Crude oil, dollar index, British pound, volatility spreads, bull spreads on financial stocks and U.S. versus German bonds
Crude oil and equity markets
Few traders could have been comfortable heading into last weekend with equity indexes on their lows following a mighty one-day decline. We pondered what this might mean for Monday’s opening once the G7 meeting of finance ministers was out of the way, and what it might mean to the Asian tigers, whose stock markets had led a third quarter charge into brave new territory. In this column last week we noted the weak technical picture for the Nikkei, but fundamentally strong forces driving the Hang Seng index higher. The 21-day average was fiercely broken in Japan, while Hong Kong investors have hardly noticed.
Oddly, the series of events didn’t seem to stack up. Equity index futures and commodity prices were behaving in far too a linear fashion. Too much logic in the equation, it seemed In the middle of last week, investors didn’t appear to mind the low bar expectations set for third quarter earnings. As results poured in they were in line with expectations, so that by the weekend S&P 500 index companies were showing a 0.6% decline over a year ago. Some 27% of companies missed target compared to 22% last year. But this is supposed to be the quarter when all of the bad stuff gets thrown out, so why did investors panic last week?
The catalyst would appear to be a brief spike in the price of oil above $90 per barrel on Friday morning. Then again, it could also have been a record low in the value of the dollar index that unsettled investors. More likely it was the combination of the two events and perhaps investors sat up and read the potential roadmap for future inflation and consumption.
Dollar index
Since commodities tend to be priced in dollars, weakness translates into higher commodity prices. Because the euro has dramatically strengthened, the price that Europeans pay for crude oil hasn’t risen anywhere as near as much as American consumers pay. So while the price of crude might have been on the rise last week thanks to strong global demand, it wasn’t acting as any sort of brake on economic growth abroad since price pressures have been disguised by dollar weakness. However, it gets worse. As the dollar weakened it actually put further upward pressure on commodity prices (including oil) since investors seek the safety of all hard assets to divest from the crumbling dollar.
It’s probable that equity investors began to juggle the dual prospects of an ever-weaker dollar and ever-rising oil prices and realized the snare it might present to the American consumer. Add in a fresh dose of reality served up to the housing market with Mr. Bernanke echoing his predecessor’s pessimism, and you have a mighty bleak picture. Hence American investors were faced with the arrival of global selling pressures on their doorstep on Monday morning.
British pound
Of interest is the dollar’s response that day. The G7 communiqué acknowledged how the price of oil might suffocate growth. It also admitted the 800-pound gorilla in the room otherwise known as the housing market. The dollar quickly fell but for the briefest moment ringing a new all-time high for the euro. However, the dollar then proceeded to surge on the theory that currency market volatility would return as investors bailed out of the so-called carry trade. The yen surged and the smile was wiped off the faces of the euro and British pound pretty sharply. The pound hit $2.053850 before losing almost three whole cents to reach $2.0259.
Once again, higher perceived trading risk was slammed home, creating linear, knee-jerk reactions that made little sense. Now that the dust has settled, the euro and British pound are both sharply higher and stock markets have miraculously found their feet. So what can we read between the lines? That the stock market should go down with the dollar? Or that financial calamity shouldn’t really be associated with a surge in the price of gold, because the carry trade gets taken off?
Dec gold traded as high as $772.85 per ounce on Friday as the dollar slumped, but slid all the way back to $751.60 on Monday morning amid the panic of a rally for the dollar. Again this made little sense to our observations.
Volatility index (VIX)
The price of crude continued to slip Tuesday and as of the closing price, had shed 5.7% from last week’s record high. Traders are holding off buying more contracts in the expectation that supplies are adequate entering the winter season. That doesn’t mean that crude won’t rally later in the week. For now, much of the bearish sentiment surrounding supplies thanks to Kurdish and Turkish clashes in Northern Iraq have fallen by the wayside. Further positioning by the Turks now in the form of missile launches would set alight the crude oil complex. Indeed, traders today are dealing with the advent of such action, coupled with Turkish troop excursions into Iraq.
It’s at times like this, when volatility is at the epicenter of whipsawed trading decisions, that investors have a hard time staying the course. When this is the case, we look to the VIX index itself to see what investors are making of the move. In equity market terms, we’re still unsurprised to see the November VIX future trading at above a reading of 20. That is high given the pattern over recent years, but low in comparison to the heady readings over the summer when the index hit 37. A reading of 20 implies a plus or minus 10% departure from the current S&P 500 index price ahead of expiration.
Despite the most devout efforts of global investors to start the week, the S&P 500 closed Tuesday 1.3% higher than Friday’s value if only accompanied by a higher reading of fear. Investors in the so-called “fear gauge” appear to have ratcheted the bar a little higher. We keenly watch options trading patterns on the index and on Tuesday noticed a fair amount of selling on the out-of-the-money puts in the November series at strikes 18 and 19. Meanwhile decent buying at the 16 and 17 puts looks like a nirvana-type scenario whereby a stock market rally would accompany a soft economic landing, which in turn would be perceived as a VIX comedown play. That scenario doesn’t really sit comfortably next to the problems with the housing market.
Investors also seemed to bolster the view that volatility was set to resume its upward trajectory by writing premium or selling puts at the November 18 and 19 strikes. The real directional plays were made on the call side where investors spent money on buying calls at the popular 22.5 and 25 strike prices. The market did register some sales at the 30 strike, which affords the trader the luxury of making those lower strike call purchases a little less costly. At the same time the investor establishes a ceiling for the amount of profit to be made from the trade.
Sovereign Bank (SOV) – bullish options play
In Monday’s session, we saw financial stocks tick higher despite the fact the market was lower. We’ve noted before that this is the sector to watch as far as gauging the overall health of the market. We were surprised to see financials rebound so strongly, yet rebound they did. Take a look at the following bullish trade established using options on Sovereign Bancorp (SOV) last week, in which a trader used a similar call spread strategy in an effort to capture an excursion to the upside before next January.
Shares in Sovereign have declined steadily over the course of the late summer and early fall, but it appears that through the call spread, a trader is betting that the worst may soon be over for Sovereign and is expecting a pull back to the $17.50 level last seen in August – but not above the $22.50 level of one month earlier. Selling that upper strike as part of the spread strategy caps any upside. The chart shows the window into which the investor needs the share price to climb in order to make money.
Options can make a bull case for a January rally into this price window
We also noted a large amount of call buying on shares in Merrill Lynch on Tuesday ahead of Wednesday’s earnings. The stock set a fresh 52-week low at $64.65 while a trader placed a large bet via the November 75 call series that shares would rebound 15% before expiration arrived. This morning the only impact that Merrill’s trademark bull registered is to boost the bull market for volatility.
U.S. notes and German bunds
Whenever the equity markets get a case of the shivers it’s the bond markets where traders seek safe haven. As tradition has it, weaker equity markets mean less wealth and potentially less spending. That’s less inflationary and - depending upon the severity of the downturn for equities - potentially recessionary. If the move is earth-shaking, investors perceive that central banks will ease monetary policy and lower interest rates. In general, a weaker level of growth ought to be consistent with lower bond yields. The following chart compares the six month performance of U.S. 10 year notes with German bunds. As prices move higher, yields or the interest rate on them moves lower.
U.S. note prices (blue)
German bunds (black)
The peak on both government bonds occurred around one week before the Fed actually cut rates. The yield on U.S. notes at the time was 4.32%, which had fallen from 4.79% at the beginning of August. The yield on German debt fell from 4.34% to 4.07% at the same time. The impact of the Fed’s action created a sense that some order had returned to the global economy and bond yields began to rise. But just five weeks on and with further fed easing baked in to the cake next Wednesday, bond yields are once again on the wane. The U.S. yield at 4.36% stands 4 basis points above the September panic low. The German yield stands today at 4.17% and 10 basis points above that September low. Overall the U.S./Germany spread has narrowed from 45 basis points at the beginning of August to 19 basis points today.
Spread traders probably wonder if the yields will reach parity anytime soon. That would take several more Fed moves at the short end creating further potential weakness in the value of the dollar. Stranger things have happened.
Andrew Wilkinson is senior market analyst and Rebecca Engmann Darst is equity options analysts for Interactive Brokers.
Source for all charts is Interactive Brokers Group Inc.
ibanalyst@interactivebrokers.com
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