In this morning’s Macro Wrap, I noted that interest rates were actually much higher now than they were when the Fed first mentioned tapering back in May. My conclusion:
While interest-rate sensitive sectors were some of the strongest performers on yesterday’s bounce (most notably, REITs and housing-related stocks), the plain fact of the matter is that rates are much higher than they were 3-6 months ago. While the Fed would like to see long-term U.S. rates go lower, other asset classes and geographies are reacting much more violently to the central bank.
If that rate stickiness continues (regardless of whether the taper comes in Oct, Dec, or 2014), my hunch is that the rotation that we saw yesterday is more likely to reverse. Financials and health care will once again attract funds and outperform. Emerging markets and U.S. real estate-based investments will resume their descent. Beware the rate sensitive head fake if rates don’t actually comply.
But the charts also indicate that this rate sensitive rotation might be near an end. For example, IYR has rallied all the way back up to its 200 day moving average and its declining 100 day moving average:
In contrast, the past week has been unkind to the regional bank ETF, the KRE, which has actually declined this week to near 2 month lows:
While KRE was rejected at its 50 day ma yesterday, all of its moving averages are still rising, and the 33.50 level (marked in red) is important and likely strong support.
So I view the potential downside risk at this juncture as much greater in IYR than in KRE, from both a fundamental (rates are still high) and technical perspective. If that rotation is close to done, then this trade takes advantage of a reversion back to KRE outperformance:
NOTE – THIS TRADE WOULD BE DONE WITH KRE PIECE WITH 2 TIMES THE SIZE AS THE IYR PIECE. IT IS NOT 1 for 1.
TRADE: KRE ($35.27) Sold the Oct 34 Put at $0.38
-Sold 2 Oct 34 Puts at $0.38 each for a Total of $0.76
Break-Even on Oct18th Expiration:
Profits: Profits up to $0.38 when stock between 33.62 and 34 on Oct18th expiry, with max profit of $0.38 at 34 or above
Losses: Unlimited (well, $33.62) below $33.62.
TRADE: IYR ($67.19) Bought the Oct 66 Put for $0.99
-Bought 1 Oct 66 Put for $0.99
Break-Even on Oct18th Expiration:
Profits: Profits unlimited (well, $65.01) below $65.01
Losses: Up to $0.99 between 65.01 and 66 on Oct18th expiry, with max loss of $0.99 at 66 or above.
Trade Rationale: The KRE trade would be done at 2 times the size as the IYR trade (so about the same notional). It ends up being a slight debit of $0.23 in total. ($0.76 credit in KRE vs. paying $0.99 total in IYR).
One last point – if you do not have sufficient margin to do this trade with the short naked KRE put, then you could do this spread trade with put spreads instead. We were comfortable with a short put since KRE is an ETF, which has less idiosyncratic risk for an outsized move through strike (at least, that would not be matched by gains in IYR).