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Bond investors lost more than $1.2 trillion last week as interest rates spiked after the election results took most by surprise and put Donald Trump's policy plans front and center.
President-elect Trump's plans for fiscal stimulus and tax cuts sent bond investors running for cover after more than six years of historically low rates. The fear is that quickened government spending and economic growth could stoke inflation, especially at a time when unemployment is already low and wage growth is starting to pick up.
Rising inflation could force the Federal Reserve to raise its benchmark interest rate faster than expected. The central bank is already widely expected to boost rates in December, with fed funds futures putting the likelihood at more than 90%.
As is usually the case, though, the herd may have gotten ahead of itself. While rates are bound to move higher through next year, we still have two months before Trump is sworn in. And it could be a year or more before he's able to deploy the fiscal stimulus he promised during the campaign.
Even a 50-basis-point move by the Fed next month doesn't justify the current panic in the bond market, so traders who get positioned now can take advantage of the recent rout. With today's trade, we can turn a small rebound in bonds into big gains before Trump gets the keys to 1600 Pennsylvania Avenue.
There's Blood in the Bond Market Streets
Rate-sensitive sectors such as utilities, real estate and consumer staples have taken it on the chin over the past week. Bond were hit hardest, though, and we've rarely seen interest rates (which move inversely to bonds) go so high, so fast.
The 10-year U.S. Treasury note added 35 basis points in the three trading days following the election, a gain of almost 19%. Such a swift percentage gain has only happened one time since 1962 -- in early January 2009 when the market went into crisis mode after a horrifying jobs report during the financial meltdown.
Meanwhile, the relative strength index (RSI) for 10-year Treasuries jumped to 83 on Monday, the highest point since 1990, signaling bonds are oversold -- at least in the short term.
The recent bond sell-off looks overdone for a number of fundamental reasons as well. For starters, there are still more than $10 trillion in global bonds with negative yields, which should keep a lid on U.S. rates as foreign investors reach for yield.
Next, the recent rise in U.S. yields may do a lot of the heavy lifting for the Fed. Borrowing costs are rising on the mere expectation of faster inflation, which could help to reduce the economic momentum that would actually create those pricing pressures.
Within the bond market, emerging market issues have been slammed. The iShares JPMorgan USD Emerging Markets Bond (NYSE: EMB) fell as much as 6.5% in the week following the election. That may not sound like a plunge in comparison to stock price moves, but it's a huge move for a bond fund, which should normally be much less volatile than stocks.
Downside moves over 5% in EMB in this time frame have only occurred three times since the financial crisis. Following these instances, the fund posted an average gain of 3.6% over the next two months when adjusting for dividends, and it was 11.3% higher on average over the next six months.
In short, EMB is oversold and due for a recovery. Shares already started to rally on Tuesday, so it looks like it's time to jump on board.
But rather than buy shares outright, I want to utilize a simple call option strategy that can turn a small rebound in EMB into a much larger gain.
Amplify a 2% Move in EMB Into a 27% Return
With EMB trading around $110 at the time of this writing, we can buy an EMB Jan 105 Call for around $5.50 per share ($550 per contract, which controls 100 shares). Our breakeven price is $110.50 ($105 strike price plus $5.50 option premium), which is less than half a percent above current prices. Plus, the call costs only a fraction of what it would cost to purchase 100 shares of EMB outright.
My upside target for EMB is $112, which is just 1.8% above current prices. If shares hit my target before the option expires on Jan. 20 -- Inauguration Day, coincidentally -- the call will be worth at least $7 ($112 stock price minus $105 strike price) for a 27% return in just over two months. Set a good 'til cancelled (GTC) sell order at $7 for the option after opening the position.
I like this trade for its short-term upside, but I'm adding bonds to my long-term portfolio as well. There is a reason why investors rely on bonds as a safety asset, and big swings like this rarely last before the market realizes its mistake.
Finally, you could consider another entry-level call option strategy that is a simple, conservative way to bring in an extra $3,000-plus a month -- from stocks or bond funds you may already own. Find out how here.
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