A Cheap Speculation

Shortly after putting yesterday’s column to bed, futures
trader Richard Morrow rang our office to announce, "I’m
shorting bonds…I LOVE this trade!"

"Which bonds?" we asked, "and how are you doing it? What
instruments are you using to go short?"

"I’m buying puts on the 10-year Treasury," he replied
breathlessly. "I don’t think I’ve ever seen bond options
this cheap!"

(In yesterday’s column, we raised the possibility of an
imminent sell-off in the bond market. So naturally, we were
eager to hear the details of Richard’s trade).

"So how cheap are they, Richard?" we asked.

"Well the implied volatility on the options is only about
5%, even though the average monthly volatility of 10-year
bonds during the summer months is more than 7%."

"You mean bonds are seasonal, just like corn and soybeans?"
we asked.

"Yeah, except the government never seems to harvest its
liabilities. It just sows ’em and watches ’em grow…
Anyway, the implied volatility of the options should be
much closer to 7%, but since bond prices have been moving
straight up for several weeks, put option volatility has
compressed, just like you would expect."

"And that’s not usually a good sign, right?" we asked.

"Right," Richard replied, "when option volatilities fall,
prices usually fall pretty soon afterwards. So I’m gonna
load up on these things, but only a little at a time. I’ve
only bought about 1/2 of my put option position, so far."

"We like the idea, Richard," we said. "Options seem like a
good way to go on this trade. We know why we’re bearish on
bonds right now, but what makes you so negative on Uncle
Sam’s obligations?"

"Well bonds yields seem extremely low, whether you compare
them to the CPI or to the GDP growth rate or to almost any
other relevant data series.  The facts are as follows:
First quarter GDP growth was 3.5%.  The CPI over the last
12 months was 3.5%, which is close to a 10-year high. Hedge
funds and Wall St. have somehow convinced themselves that
interest rates are going down no matter what the data
says."

Interest rates today remind me a lot of the euro last
Christmas at 136. Everyone was bullish on the Euro at 136
and they were all wrong. I would submit that a sub-4% 10-
year Treasury makes less sense than a 136 Euro.

"Long story short," Richard winds up, "the 10-year would be
yielding between 6% and 7%, if it were trading in line with
its historical relationship to the CPI, GDP and the current
stage of the interest rate cycle.  So that analysis makes
out-of-the-money puts look awful cheap on a reward\risk
ratio basis. By the way, I’m early on this trade because
I’m always early on financial trades. That said, bonds
gapped higher two days in a row and the market was way over
the moving averages. I feel that this technical set-up is
very shaky for the bulls."

"Thanks Richard, and good luck on the trade."

Options on futures are not for everyone, of course. Some of
us might prefer a more sedate means of betting against
bonds. Happily, the Rydex family of mutual funds offers an
interesting alternative, the Rydex Juno Fund. This unique
fund holds short positions in long-dated Treasuries. Thus,
each 3/32 change in price of the long bond means
approximately a one-penny move in the share price of Rydex
Juno.

A much simpler way to think about the fund is that its
share price rises when yields rise and falls when yields
fall. Thus, the fund has been a very poor investment lately
– falling as bond yields have been falling. But if bond
yields are on the brink of reversing course, as Richard
suspects, Rydex Juno may be on the verge of delivering
gains to its shareholders.

On the other hand, betting that bond yields will begin
moving higher – as seems appropriate in a world of rising
GDP, commodity prices and inflation – is a trade that
appears to offer more reward than risk. This morning’s
weaker-than-expected jobs report, which has sparked another
bond rally, might provide an ideal opportunity for bond
bears to show their teeth.

We’ve been wrong before, of course, and so has Richard. But
the short side of the bond market seems like a worthwhile
speculation.

Did You Notice…?
By Carl Swenlin

During the last four weeks of the price correction that
began at the March top you will notice how cash flow went
relatively flat, indicating that the bulls were holding
their ground and that accumulation was taking place.
However, since the two-week rally that began at the May
price low, cash flow has been rather tepid, and was even
flat during the first week of the rally.

It is probable that energy stocks have completed a medium-
term correction and are poised to move higher, but the lack
of sponsorship and overhead resistance warn that we could
see a partial retracement of recent gains, particularly in
the Energy Service sector.

Cash flow divergences provide valuable clues that can help
us prepare for price action others are not expecting, but
they don’t always result in the kind of price move they
imply. Always wait for prices to make the expected break
before acting.

My observation is that these cash flow divergences only
have short-term implications. Also, it is important to
remember that the Rydex sector funds only account for a
small slice of the total market in a given sector, and this
small picture may not be representative of the big picture.