With the indices revisiting the all-time highs for the first half of the week, it begs the question ‘Why are bond prices remaining so elevated?’ and ‘How can I take advantage of this anomaly?’ The energy markets have shown some renewed volatility with the ebb and flow of possible hostilities in the Ukraine while the metals markets continue their relative flat line price discovery.
The indices continue to remain within striking distance of new highs after last week’s sharp sell off with the S&P 500 (CME:SPM14) nearly breaching the key 1800 price level. This was seemingly and over reaction to the Russia-Ukraine conflict as the market nearly immediately took back half of the decline and has spent the subsequent six sessions grinding higher. The most interesting bi product of this has been the reaction in the 30 year bond futures.
As one would expect, there was a sharp spike in the bond pricing (inverse of the yield, see chart below) as the equities sold off and the correction was reasonable as well, trading back down two full handles (32 tics per handle, $31.25 per tic on the $100,000.00 contract). Since then, we have seen the bond market trade slightly higher in tandem with the S and P which is not the normal relationship for those two normally opposite moving commodities. As the U.S. economy moves closer toward the finalizing of the QE bond purchasing (est. September 2014 for the final taper) allowing the economy to attempt to stand on its own two feet, the possibility of rising interest rates would seem to put pressure on the 30-year instrument, particularly with the equity indices doing so well. That seeming inevitability has not been playing out as one would have expected. Prior to QE 3 the bond market was trading between a 105 handle and 125 handle.
During the record asset purchasing of the FOMC over the past several years, we saw the 30 year bond trade as high as 154 handle. It currently is stymied in the mid 130’s. While that pricing is well off the highs, it seems to have a long way to go to get back to where the market had fairly priced it prior to QE 3. This is a development in the market that, at some point, should return to the mean. The difficultly is figuring out the most effective method (options, futures, spread, combo, etc.) in attempting to take advantage of the eventual correction. The reluctance of the 30 year bond price to decline dramatically has led me to think that there could potentially be a more effective method for participating in this potentially significant market event.
Through use of the yield curve spread (different durations of U.S. note and bond futures spread against one and another) we can ‘fade’ the ‘flattening’ curve (in terms of price, flattening is when the long term price trades dramatically higher than the short term price making the rates between the two closer). Thus, selling the 30-year bond and buying the 10-year note would position one for when the curve began to normalize, in this case steepening. Therefore, the trade can make a profit by either the 10-year rallying more than the bonds or the bonds declining more than the ten year. Utilizing a ratio between the two instruments can further enhance the risk profile for the position as well as create more maneuverability in the price discovery (please click here and here to see detailed descriptions of this). This type trading can produce a profit in the right environment whether the market goes up or down.
The chart shows a Black Line Bond Yield and Red Line Bond Price.
The crude oil (NYMEX:CLM14) and gasoline markets have shown some big moves to the upside due in part to the Russian concerns and possibly in part to the seasonality of the energy products. The ‘fear’ rallies based on geo political strife are normally discounted rather quickly as we saw with the 2 dollar decline in the crude oil yesterday. However, there does appear to be some seasonal support below the current pricing in both crude and RBOB. Normally, the seasonal play in the futures should be priced in to the value of the contract, though this particular spring could produce a sharper bid effect as consumers may have a larger appetite where fuel consumption is concerned following such a harsh winter that has left many with significant ‘cabin fever’.
This support can be taken advantage of in several ways, depending on the participants risk profile. Long calls are the safest form though must be the most precise. Out right futures are the riskiest though the most profitable. Some amalgamation of these tools probably achieves the greatest opportunity while still representing a reasonable risk.
The precious metals markets have been just the opposite, having spent seemingly months mired in a relatively tight range. The gold (COMEX:GCM14) and silver (COMEX:SIM14) both have shown great opportunities to write premium in the options, particularly to the down side as the support in the 1100 handle for gold and the high teens for the silver seems very strong.
However, this strategy does have unlimited theoretical risk, so it is not one that should be utilized without some other form of a spread to limit that risk.