Investors May be About to Bail on This ‘Safe’ Asset
The yield on the 10-year Treasury note jumped to its highest close in two weeks Friday when a surprise rate cut by China’s central bank boosted markets and eased demand for safe haven assets. The People’s Bank of China cut its one-year lending and deposit rates by 0.25 percentage points to bolster economic growth.
Fears over a rate hike by the Federal Reserve have subsided lately. Little is expected from today’s Federal Open Market Committee (FOMC) meeting announcement, and investors put the odds of a rate hike in December at 34%.
Yet, even without an actual increase in the federal funds rate, several other factors are likely to drive interest rates higher through the end of the year. That’s bad news for bond investors because bond prices fall as interest rates increase.
With today’s trade, you could turn their pain into a 79% gain in less than three months.
Bonds Could Take a Hit Even if the Fed Does Nothing
As the Federal Reserve increases the fed funds rate — the rate banks charge each other on loaned reserves — the rate on all interest products increases. However, that’s not the only thing that could cause U.S. bond yields to rise in the near term. China’s policy measures, European interest rates and U.S. economic strength could also have an impact.
As I mentioned earlier, lower rates in China caused rates on the U.S. 10-year note to rise last week. But higher rates elsewhere could have the same effect. Let me explain…
While U.S. interest rates were relatively flat this year until recently, rates in Europe have surged. The average rate on the 10-year bond across the euro area has increased 21% since April, and the German bund has jumped more than five-fold during that time. That’s important because rock-bottom rates in Europe have been blamed for strong buying of higher-yielding U.S. Treasuries.
With foreign rates increasing, the demand for U.S. bonds will decrease. Therefore, rates will have to move higher and bond prices lower to attract buyers.
U.S. economic strength could also negatively impact bond prices.
It looks increasingly likely we will see a strong holiday season. For instance, Amazon.com (NASDAQ: AMZN) is boosting its holiday hiring by 25%. The e-commerce giant said it will bring on 100,000 holiday workers, and that’s in addition to the 25,000 full-time staff it recently hired. Plus, it just reported blowout numbers for the third quarter and expects sales to increase between 14% and 25% year over year in the holiday quarter.
On top of that, a labor shortage has been building for the past year, with the four-week average for initial unemployment claims falling to its lowest level since 1973. Retailers like Wal-Mart Stores (NYSE: WMT) have responded by raising wages.
An increase in wages should boost consumer sentiment and spending. This could convince investors that the Fed will raise rates faster than currently anticipated, and in the bond market the expectation of higher rates is often enough to send yields higher and prices lower.
Make 79% as This Not-so-Safe Bond Fund Falls
Against the potential for rising rates this year, investors have sought relative safety in shorter-term bonds like the iShares 7-10 Year Treasury ETF (NYSE: IEF). The fund is up 1.9% since the start of the year, while the longer maturity iShares 20+ Year Treasury ETF (NYSE: TLT) is down 1.3%.
The idea is that rising rates affect shorter-term bonds less and prices will fall more slowly. This thinking has led to false confidence in IEF, and coming losses could turn investor sentiment quickly.
With IEF trading for $108.03, we can buy the IEF Jan 107 Puts for $1.12. That is a put option with a $107 strike price that expires on Jan. 15. Each contract controls 100 shares, costing you $112 per contract.
This trade breaks even at $105.88 ($107 strike price minus $1.12 options premium), which is 2% below the current price.
Shares traded below $105 this summer and for much of 2014 and could retest that level as we approach a possible December rate hike and start getting sales data from the holiday season.
With IEF at $105, the option would be worth at least $2 ($107 strike price minus $105 ETF price) for a 79% return in 80 days. Set a good ’til cancelled (GTC) order at that price to take advantage of any quick increase in rates.
Expectations for a Fed rate hike pushed the yield on the 10-year Treasury note up almost 25% in two months this summer and helped halt the stock market’s bull run. Even if the Fed postpones a rate increase through December, several catalysts exist to send bond prices lower. Traders who get positioned now can take advantage of the current false confidence in shorter-term bonds for a quick gain.
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