Today’s themes –Crude Oil, U.S. T-Notes, VIX index and the U.S. Dollar index
Crude oil
Precisely as the March crude oil future reached expiry on Tuesday it rang up its third stab at a triple-digit price. Having attempted to do so twice in January based on scary talk over potential Nigerian supply disruptions, the contract expired this week at $100.10 per barrel. Of course, the April contract is hot on its heels, trading as high as $100.30 on Tuesday.
Chart: InteractiveBrokers
It does make us sit up and wonder who has the fundamentals right. On the one hand, investors can’t make a rally in the stock market stick because more people fear the fallout of rising unemployment caused by recession. On the other, bond investors have abandoned ship in the last 10 days for fear of inflationary pressures building.
That’s not to say that you can’t have coincident recession and rising prices. No, that ugly mix is called stagflation. What’s going on is that the Fed’s decisive monetary response through lower interest rates is increasingly been viewed as the correct response. You can see that playing out in a relatively stronger U.S. dollar each day.
The crude reality is that the slowing U.S. housing market and the sledgehammer blows it’s delivering to Wall Street investment banks don’t hamper the growing global demand for energy. Even in the United States, cars still need filling up with gasoline and homes still need heating. So the recent recession-inspired slide back to $86.44 turned out to be a huge buying opportunity. It took 29 days to reach that low point after the first assault on $100 per barrel but only eight days to regain it. You can see the gushing momentum beneath the chart above. Thank structural deficiencies at your local refinery if you have a problem next time you’re filling the tank. With more cold weather heading for the northeastern corner of the U.S. this weekend, heating oil demand isn’t going down anytime soon – recession or not.
What’s next for the price of crude oil? One thing that is for sure is that $100-plus per barrel is now a reality rather than just a wild fear. And what’s more, this recent run-up had nothing to do with supply-side fears. There are no Kurdish-Turkish fist-fights to spark this flame today. It’s simply strength in demand.
U.S. T-notes
If the fed funds rate is at 3% and if the Eurodollar market predicts a 100% chance of a half-point cut at the March meeting, because the economy is plunging south at meteor-like speed, then what yield should the 10-year government note carry?
Chart: InteractiveBrokers
On January 23, notes popped up in price, sending yields down to 3.28% - a new low for this cycle. Only on seven occasions since that date has the yield closed lower than 3.60%, which tells us how reluctant bond buyers are to press the point. In other words, there is a significant degree of reticence among buyers to feel cozy in the view that inflation is merely on the back burner for now, or that monetary priming today will be replaced with the monetary club before we know it.
The chart above does suggest a top in place. However, this could also be akin to the same type of formation in December, when a huge run-up in prices suddenly faltered into year end. But soon the trend resumed. The yield spread between the two and 10-year notes has widened significantly of late, despite the similar recoil in the price of the two-year note. Going forward, the question any option trader is asking is whether further monetary easing will witness a note rally, creating downward pressure on the spread. If the spread does narrow, the smart way to play the debt market might be through options at this stage.
For example, with 60 days before the June option expires, the current 55/64 price of the 117 strike call option would rise to 1-15/64 allowing for 30 days time decay if the June future rallied to the strike price from its current 114-10/32. In doing so, the note would have to rebound about two-thirds of the recent move lower, which is certainly achievable for anyone who believes that the Fed’s work is far from done.
S&P 500 index
We wondered last week whether the major move down for stocks might have run its course. And despite sharp intra-day swings and top-to-bottom reversals – the index has subsequently traded sideways since. Volatility continues to remain tempered and the reading of 28 on the CBOE’s VIX index continues to contain any temper outburst when the market turns moody.
That does beg a question, however. If the S&P 500 index does test the downside once again, assuming a lethal cocktail of domestic slowdown-talk and higher oil prices, what will happen to volatility readings? That’s a fair question, we think. On the one hand, any slump in equity prices will likely continue to display an orderly meltdown. Don’t forget – investors know the rules these days. The economy is slowing, financial companies are in trouble, but have displayed much of what’s below the waterline and the Fed is acting fast to counter the slowdown. On the other, whatever catalyst does create further meltdown is likely to be a current unknown and would create a new temporary fear factor.
Chart: InteractiveBrokers
The VIX April contract call option at the 30 strike is currently quoted at around 1.40 points. Incidentally, it’s the most widely traded series in today’s session. A seller at the price would break even at 31.40, and benefits from a reading of theta or time decay of 2 cents per day. The extrinsic value of any option premium decays whether the option wanders into the money or not. In other words, if the VIX marked time for the next week, the price of the call would decline by around 14 cents. Of course, a 30 strike call would remain worthless at expiration at any VIX index reading below the strike. If you’re thinking of selling volatility the next time stocks swoon, work out precisely where you’d like to sell ahead of time to achieve the biggest bang for your buck.
U.S. dollar index
The last seven years has seen the broad demise of the dollar. Sell it and buy anything else. There hasn’t been a period for quite some time where the individual merits or otherwise of any currency have been so clearly magnified. Sell the dollar; Play the carry trade and the latest twist was to carry the commodity dollars thanks to the twin benefits of their high growth and subsequent high yields.
We wondered last week whether the Australian dollar might quickly follow the same trajectory of the Canadian dollar, but a robust employment report in Australia has investors betting on ever-higher rates. The divergence between the two key commodity dollars was highlighted this week.
Suddenly the U.S. dollar is no longer the whipping boy it once was. The euro is stepping into the spotlight, where the ECB rate-setting board stands the potential for pulling the rug from beneath the euro’s feet via its intransigence in acknowledging recessionary risk.
The yen and the Swiss franc are the major beneficiaries from an overall reduction in risk appetite and find themselves dusting themselves off after a prolonged street-fight against the dollar. But the dollar index, as shown below, isn’t suffering from this fact. Selling in the British pound picked up after the government came under some nasty accusations while it nationalized that nation’s fifth largest mortgage lender, Northern Rock. Investors clearly see a rapid deterioration in the prospects for the pound as contagion from the U.S. economy gathers pace.
Chart: InteractiveBrokers
Andrew Wilkinson and Rebecca Engmann Darst
ibanalyst@interactivebrokers.com
Note: The material presented in this commentary is provided for informational purposes only and is based upon information that is considered reliable. However, neither Interactive Brokers LLC nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Neither IB nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.
This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities or other financial instruments mentioned in this material are not suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice and are only correct as of the stated date of their issue. The information contained herein does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation to you of any particular securities, financial instruments or strategies. Before investing, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
