Earlier today in my MorningWord I highlighted the conundrum of the data dependent U.S. Federal Reserve, faced with U.S. economic data hitting their prior targets for employment and inflation and the possibility for renewed tightening, vs the backdrop of a stagnant at best global economy and the potential knock-on effects of further tightening. Here was my view on what this morning’s jobs data means:
It’s been my view for some time that the sources of the next U.S. recession are unlikely to come from domestic factors, and is much more likely to come from offshore. And while U.S. stocks breathe a sigh of relief, there still does not appear to be any fundamental improvement in the sources of volatility over the last year. What has changed is fear abating somewhat in commodities and credit.
So why would the warnings sign start flashing again? From stronger U.S. data, strengthening the dollar on higher rate expectations, despite a stagnant global economy forcing lower rates the world over, and even negative rates. In that scenario the Fed’s divergent monetary policy could exacerbate economic strains overseas, especially in emerging markets which need higher commodity prices.
A strong U.S. economy is more than welcome after 7 years of massive QE and ZIRP, even a fragile one. But it makes me less sanguine about global growth given what is likely to be the continued strength in the U.S. dollar. And in many ways that disparity in growth is the very thing that brings volatility back to our shores, as it is the root cause of recent contagion pressures in commodities, currencies and credit.
If the dollar does at the very least hold its ground, and that means commodities eventually give back some of their recent gains, and lower for longer oil could very well cause the defaults, re-organizations and ultimately bankruptcy fears that were the result of last year’s weakness in high yield credit. If there is in fact another leg lower for industrial commodities, specifically oil, that once again stoke systemic credit fears, coupled with what so many have warned as poor liquidity in credit markets, particularly high yield, causing another risk asset panic like we saw in January and early February.
And what of the 25%+ of the world’s GDP that has central banks that have instituted negative interest rates and their effect on credit? As my friend Brian Kelly just stated to me “Negative rates cause people to hoard cash. This is recessionary and as such will lead to higher default rates”.
For those who think that divergent monetary policy will cause another bout of risk asset volatility, shorting the recent bounce in high yield could be the way to play for the next credit contagion sell off. But you want to have time on your side. The HYG, the iShares High Yield Bond etf has rallied about 8% off of its recent lows from early February, but remains 11% from its 52 week highs. The HYG remains in a very sharp downtrend over the last year:
And short dated options prices in the HYG have come in very hard, down almost 50% from its late 2015 highs, with 30 day at the money implied volatility at 9.6% vs a high of 19.8%, with June near the money IV just above 10%:
So what’s the Trade?
If you agree that the most bang for your black swan buck will be in the HYG, with options prices at the very least fair, to possibly cheap, long premium, directional trades could make sense. This is a trade I might consider with an entry closer to $82, which was a breakdown level, but gun to my head, here is the trade now:
HYG ($81.20) Buy June 80 / 70 Put Spread for $1.90
- Buy to open 1 HYG June 80 put for $2.15
- Sell to open 1 HYG June 70 put at 25 cents
Break-Even on June expiration:
Profits: up to 8.10 between 78.10 and 70, with max gain below $70
Losses: up to 1.90 between 78.100 and 80 with max loss of 1.90, or 2.3% of the etf price.