USD 10y Yields are low.
Equity market (S&P 500) and Bond Market (UST 10y) investors are presenting a divergent picture of the economy. Rally in Equity market to year to date highs on the back of better than expected economic indicators is not being supported by the fall in yields of bond markets. Why? Is this equity rally is not a sustainable one? Or Bond investors are worried of inflation but the Japanese style deflation? Is there a mispricing of the risk in the market? Before going further, let us review some historical data. Historically, equity market rally is accompanied by bond market selloff. This fact is shown in the Exhibit A. Data goes back to 1999.
Next exhibit shows the point under discussion
Clearly since early august both markets have diverged. This brings us back to the questions we are pondering above. On the question of sustainability of rally, this is more fundamental question as market is pricing in recovery and looking for stronger economy. The economic indicators that came in august, strong housing reports, strong manufacturing activity reports and better employment report and lower inflation numbers shows FED has succeeded in pulling economy out of ditch. That said market is definitely poised to rise higher at the behest of various government programs. So at least it is safe to assume for now market rally is sustainable (on a short term basis). Our next question is with regards to deflation vs inflation. Looks like Bond investors are supporting the case of deflation instead of inflation. Now question is the current bond yield levels of 3.5% are lower or higher. I believe they are at lower levels. I have fitted a simple regression model using libor-OIS spreads, SP500 as independent variables. I have chosen libor ois spread because, these days libor is setting lower and causing the yield curve to get pushed lower. After fitting the model, I found the model explaining the yields very well with a R square of 0.8. Now if that is the case then current low level of UST 10y yields are going to rise in near future. Yields might visit the area of 3.75 to 3.80 atleast.
How to monetize this rising rates view? Buy some treasury put options or sell some treasury call options. For this view, I will choose TYZ9 oct options.
Buy TYZ9 100 116 Oct puts at 0.54 ticks, 84,375.
Equity market (S&P 500) and Bond Market (UST 10y) investors are presenting a divergent picture of the economy. Rally in Equity market to year to date highs on the back of better than expected economic indicators is not being supported by the fall in yields of bond markets. Why? Is this equity rally is not a sustainable one? Or Bond investors are worried of inflation but the Japanese style deflation? Is there a mispricing of the risk in the market? Before going further, let us review some historical data. Historically, equity market rally is accompanied by bond market selloff. This fact is shown in the Exhibit A. Data goes back to 1999.
Next exhibit shows the point under discussion
Clearly since early august both markets have diverged. This brings us back to the questions we are pondering above. On the question of sustainability of rally, this is more fundamental question as market is pricing in recovery and looking for stronger economy. The economic indicators that came in august, strong housing reports, strong manufacturing activity reports and better employment report and lower inflation numbers shows FED has succeeded in pulling economy out of ditch. That said market is definitely poised to rise higher at the behest of various government programs. So at least it is safe to assume for now market rally is sustainable (on a short term basis). Our next question is with regards to deflation vs inflation. Looks like Bond investors are supporting the case of deflation instead of inflation. Now question is the current bond yield levels of 3.5% are lower or higher. I believe they are at lower levels. I have fitted a simple regression model using libor-OIS spreads, SP500 as independent variables. I have chosen libor ois spread because, these days libor is setting lower and causing the yield curve to get pushed lower. After fitting the model, I found the model explaining the yields very well with a R square of 0.8. Now if that is the case then current low level of UST 10y yields are going to rise in near future. Yields might visit the area of 3.75 to 3.80 atleast.
How to monetize this rising rates view? Buy some treasury put options or sell some treasury call options. For this view, I will choose TYZ9 oct options.
Buy TYZ9 100 116 Oct puts at 0.54 ticks, 84,375.
