Unless you invest from under a rock, you know that the Federal Reserve meets next week to debate interest rate policy. Fed Fund futures are currently pricing about a 20% chance that the Fed will raise interest rates, that’s down from 30% on Sept 9th, and more than cut in half from August 26th when a Sept rate hike was at its zenith with a 42% probability. Despite the low probability of a Sept hike, there continues to be some debate about whether or not the Fed should surprise on this front, which I think is quite silly. I wrote about this Wednesday, (Basket of Predictables):
Let’s first look at the math. Goldman Sachs research found that (since 1994) 90 percent of (the 31) rate hikes were priced by Fed Futures at 50% or higher 30 days ahead of the FOMC meeting. What that means is the Fed doesn’t like to surprise investors. If they’re going to hike they telegraph it ahead of time.
Of course, one of the main tools in the Fed’s toolbox is surprising markets. But that is almost exclusively reserved for rate cuts in the midst of market/economic panics. Think back to Greenspan’s surprise rate cuts in early 2001, or Bernanke’s discount rate cut at the onset of the financial crisis in Aug 2007 and then the aggressive move to zero for Fed Funds in 2008. That surprise is often just the jolt the markets need and show determination to spur investment in risk assets, or lending. Surprise rate hikes have the opposite effect.
And to surprise with a hike, in the midst of an already fragile economy would be asinine. Throw the potential political implications in and there’s just no way. It’s not in the Fed or Yellen’s DNA. I know, I know the Fed is supposed to be an apolitical organization. But they know an election is coming up and the last thing they want is to be seen historically as having affected it with a rate hike. And don’t think Donald’s Trump’s recent rhetoric that Fed Chair Yellen should be “ashamed” of what she is doing to the country (keeping rates low and steady) will cause her (and the FOMC) to go the other way. No one will ever remember that they didn’t raise rates into an election. Trump is simply playing a no lose hand with those statements. His populist message about the damage the Fed is doing plays with his base, and maybe even reaching some Republicans and libertarians that are not his current supporters. But it will not bully the Fed into tightening.
Last week, Bond King, Jeffrey Gundlach of DoubleLine Funds held a quarterly webcast (which is widely followed by investors and the financial media) where he made a strong case that bonds yields have bottomed long term, and that the “narrative” about low yields in a world where more than $14 trillion of sovereign debt has a negative yield is about to change in a very “bond unfriendly manner”. Whether it was a confluence of events, or merely Gundlach’s message last Thursday, bond traders got the message. 10 year treasury yields made only their second close above 1.6% since late June the following day, and they’ve held their gains this week, despite the declining probabilities of a Sept and Nov rate hike:
I’m not a king of any kingdom, merely an equity-option court-jester. So I’ll turn it back over to Gundlach and his belief that the Fed is annoyed by the assumption that their hands are tied by Fed Fund futures. He is very clear that he does not think they will raise in Sept, and that if they did they would be doing so into weakening economic data. But he feels they desperately want to prove their independence from such forecasting. If only to prove that they “are not controlled by the market”. Which has been the knock on this particular group for some time.
Gundlach also made the point that the recent data (specifically the Aug ISM nearing some of the lowest levels since the start of QE in 2009) places the U.S. economy on recession watch. But Gundlach thinks the Fed may “blow themselves up” anyway.
That’s all fine and good. And it all makes sense. But I’m still pretty sure they don’t have the cajones to prove their independence before the presidential election. So for the time being, 10 year treasury yields, without the benefit of strengthening economic data, will probably remain range-bound between 1.5% and 1.9%. And for now we are right at the mid point:
Gundlach did make a strong case that the “market’s rejection” of a new low for the 10 year yield, signaling the “exhaustion of a move”, coupled with improvement in nominal gdp, and the potential for fiscal stimulus in the new year, suggests a long term bottoming process. That is despite his feeling that rates “might not rise a lot in the near term”, but could be the beginning of something”:
I agree with most of what Gundlach is saying, and even agree that we may have seen the bottom for rates for the long term. But that doesn’t mean the short term will necessarily reflect that. So the circle I can’t square is how Treasury yields go much above the long term 20 year trend any time soon given the state of global monetary policy and the fragility of ours and the global economy. Connect the dots anyway you like but to my eye you can maybe only get back to 2.25% or so near term in the 10 year yield, and that’s with a raise and hawkish rhetoric for 2017. That happens to be just where the 10 year yield was at this time last year, and when the Fed last raised rates in Dec 2015, for the first time in 9 years:
I would also add that even with consensus that a Dec raise is almost a given, the Fed Fund futures are still only 50/50.
While I think there is a strong likelihood (no matter what happens in the election) that the Fed raises in Dec, it would take a material uptick in economic data for the 10 year treasury yield to front run 2017 hikes, and find itself meaningful above that long term downtrend.
On the flip-side, if got the 2nd and/or 3rd consecutive non-farm payroll misses in Sept & Oct, then a Dec raise could be off the table. Of course Gundlach suggests, the “Fed wants to blow themselves up” by raising into a weakening data cycle to prove their independence from “WIRP watchers”. And if that’s true, it would make sense to once again look to bond proxies (which have sold off of late) as investors seek yield.
Which leads me to some options activity in a rate sensitive sector:
Earlier this morning there was a decent size roll down and out of calls in the Utilities Select etf, the XLU. When the etf was $48.80 a trader sold to close 20,000 Dec 53 calls at 20 cents, and bought to open 20,000 of the Jan 50 calls for $1.17. These calls break-even at $51.17, up about 5% from the trading levels.
So what’s the set up? Call spreads in the XLU, targeting Dec expiration. If the Fed does not raise at their Dec 14th meeting (after punting on Sept & Nov), utility stocks will likely be back near 52 week highs at $53. And even if they do raise in Dec, we may have already seen the reaction in these stocks, and rates. The XLU appears to have fairly good technical support at $48, which also corresponds with its 200 day moving average (yellow line below), this is where I would want to define my risk to on the downside. And even if Gundlach is right and the Fed were to surprise markets with more aggressiveness, rates would move quickly, and not just bond proxies. But all stocks would take it on the chin, while my risk would be defined.
So What’s the Trade?
*XLU ($49) Buy Dec 49 / 54 call spread for $1.50
- Buy to open 1 Dec 49 call for 1.65
- Sell to open 1 Dec 54 call at 15 cents
Profits on Dec Expiration:
Profits: between $50.50 and $54 of up to $3.50, max gain of $3.50 above $54
Losses: up to $1.50 between $49 and $50.50, with max loss of $1.50 below $49, or about 3% of the etf price.
Rationale: This trade structure defines my risk very near to what would be a technical breakdown, while offering profit potential of 3x the premium at risk if these stocks reverse recent course and make their way back to the highs by year end.