Our earnings recap of the banks last month indicated a difficult overall landscape for the sector. On a sector level, the mortgage business was the particular sore spot, and the fixed income business was broadly weak for most of the investment banks as well. The robust capital markets environment was insufficient to offset the fixed income declines for most banks.
Moreover, interest rates have continued lower since those reports. The 10 year yield hit a new 6 month low on Friday. Treasury yields have moved a couple basis points higher today, but financials are still underperforming today as investors price in the impact of lower rats on financial stocks.
Erik Swarts of MarketAnthropology.com illustrated the long-term positive correlation between banking stocks and Treasury yields in Friday’s post:
Not surprisingly, the XLF / SPY ratio peaked last summer, right around the time that the move higher in long-term rates stalled. With today’s weakness, the ratio is near its 1 year lows, as investors rotate out of financials, which are now flat on the year:
With the year-to-date underperformance of the financials sector relative to the rest of the market, portfolio managers are incentivized to sell financials on any broader market weakness.
Finally, the rebound in the housing market, which was a tailwind for the banks in 2012 and 2013, has stalled. Jeff Gundlach laid out the bearish case for the housing market at today’s Ira Sohn conference. The weakness in the mortgage market that the banks have reported for the past 6 months is likely not a temporary phenomenon.
So what’s the trade?
There was a buyer today of 10k of the July 22 / Jan15 20 put diagonal for 0.07. The trader paid 0.67 for the July 22 puts, and sold the Jan15 20 puts at 0.60, for a total debit of 0.07 on the diagonal.
This trade structure is mildly bearish, with the main risk that XLF doesn’t move between now and July, in which case the short Jan15 20 puts will not lose much value, but the July 22 puts will be nearly worthless. On the downside, the July 22 puts will gain value more quickly than the Jan15 20 puts, while the initial premium outlay of 0.07 is much less than a put spread or outright put purchase. The July 22 puts are a 55 delta, while the Jan15 20 puts are a 27 delta, which means that, all else equal, the put diagonal will gain about 28 cents of value (55 delta minus 27 delta) for each 1 dollar move lower in XLF. Of course, the structure’s value will not move linearly like that, but it’s an initial approximation of the downside exposure.
That is an interesting structure for a move to the downside in XLF over the next couple of months. We currently have the BAC long put position, so we are not adding the XLF position as well just yet, but wanted to lay out the idea and highlight and interesting structure.