US 10y Yields are low

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.

Bernanke Saved my trade.

On Aug 9 i ahve recommended 119/125 bear call spread. This trade receives 200 dollars before commissions. the premise for this trade is that markets will stage a sell off. But surprisingly Equity markets started rallying and bond markets also rallying. This looks very odd.

First Trade Review: On 21st aug, this trade is deep in red on the verge of loosing 2000 dollars. Since i was doing a paper trade i was waiting for the trade to expire. at 10 A.M Bernanke came and stated he is seeing recovery signs. This gave a big boost to equity markets. Bond markets sold off. My 119 call that was ITM expired OTM. Huh what a relief.

Now on the other side, bond markets are not buying recovery but equity markets have already started getting in the mood of recovery.

bye for now. i have to go and play basket ball with my two boys

SourceL www.dismalscientist.com

Short 1000 98 EDM0 puts - Fed will not Hike

Financial Markets – Week of August 10th to August 16th 2009.
Last two weeks economic indicators telling the health of the economy have caused upward and downward revisions to GDP. Initial estimates of manufacturing activity have guided GDP estimates to as high as 4.5%. Consequently treasuries have sold off, equity markets have rised all over the week. Later this week retails sales painted grim picture about consumer spending. This caused GDP estimates to be revised back to lower 3.7%. This contributed to treasury rally and sell off in equity markets.
From this background, looking at Euro dollar futures and treasury futures for opportunities with the lens of market pricing of Fed hikes, treasury supply of debt I believe selling ED futures put options and buying treasury call options are two interesting trades.
Fed came out with it FOMC statement on Wednesday stating economy is showing signs of improvement, inflation is still low and it will keep interest rates low for an extended period at current levels. This means there will be no hikes in interest rates till second half of 2010 until this view gets revised due to incoming information. One important element is unemployment condition in the economy. This is a lagging indicator and there are more signs of worsening rather than improving. This will also force the Fed to not press the interest rate hike button.
Looking at ED strip, I see there is a gap of 40bps between EDH0 and EDM0. This means market is pricing some possibility of 25bps hike in the interest rates. But Fed is indicating otherwise. This makes a case for selling puts. So I would recommend selling puts EDM0. After deciding the contract, next element in the process is to determine the strike level of the option. Strike level of the option is based on the probability of the option attaining the level of by the time of expiry. After looking at probability chart 98 strike level is selected. Benefits of this OTM put are, this option is priced at 0.23 ticks. This means, breakeven level is at 2.23. In other words libor needs to be set atleast above this level for this option to get expired ITM. Time decay works in our favor. Cost of doing 1000 puts is 575,000. Margin requirements for this trade are approximately 600K. Although this trade ties up sufficient margin it is a good trade from the perspective of market pricing the hike, time decay and roll down perspective.
Risks to this trade are
1) Economic recovery takes at a faster pace
2) Unemployment picture brightens
3) Commodity prices rises and fear of inflation takes on hold.
4) Housing stabilizes.
Odd are that none of these scenarios are plausible.












Date
Time (ET)
Statistic
For
Actual
Briefing Forecast
Market Expects
Prior
Revised From
Aug 17
8:30 AM
Empire Manufacturing
Aug
-
5.00
2.20
-0.55
-
Aug 17
9:00 AM
Net Long-Term TIC Flows
Jun
-
NA
$17.5B
-$19.8B
-
Aug 18
8:30 AM
Building Permits
Jul
-
565K
576K
570K
-
Aug 18
8:30 AM
Core PPI
Jul
-
0.1%
0.1%
0.5%
-
Aug 18
8:30 AM
Housing Starts
Jul
-
580K
598K
582K
-
Aug 18
8:30 AM
PPI
Jul
-
-0.2%
-0.2%
1.8%
-
Aug 19
10:30 AM
Crude Inventories
08/14
-
NA
NA
+2.52M
-
Aug 20
8:30 AM
Initial Claims
08/15
-
550K
553K
558K
-
Aug 20
10:00 AM
Leading Indicators
Jul
-
0.6%
0.6%
0.7%
-
Aug 20
10:00 AM
Philadelphia Fed
Aug
-
1.0
-2.0
-7.5
-
Aug 21
10:00 AM
Existing Home Sales
Jul
-
5.10M
5.00M
4.89M
-

Bear call spread USU9 119/125

Markets have ended in a good mood last week. This week being data intensive we could see some surprises. This week, we have Treasury auctions (3y and 10y), FOMC meeting announcement and inflation data coming up. These factors have direct impact on long bonds.
Fundamental View
30y Treasury rates went up by 31bps last week. As economy is out of recession in terms of market indicators we could see another set of sell off this week. This can be punctuated by treasury funding. FOMC meeting could deliver another big dose of sell off in the market due to less down side risks. Finally rates can get low due to low inflation data. Also equity markets are supporting bond market selloff.
Technical View

MACD indicator shows trend direction is towards lower side. Also markets have not visited the previous high in early july of 122. There is a strong resistance around 120.
I will initiate short call position at 119 strike for USU9. This call will be insured by another long of 125 call. This structure is bear call spread. Net cost of this trade is 234.25 -31.25= 202 before commissions.

FOMC - a big HUH!

June FOMC statement came this afternoon and the report took away all the sizzle that was being expected by the market. One interesting thing in this report is Fed has come to an understanding that it has and will be deploying all the tools to keep economy from falling into a depression.

Fed has mentioned that growth rate fall has slowed down a bit. It has taken some comfort from how its monetary policy is helping the economy. Fed is still on it target to make its purchases related quantitative easing. Also fed has come to clear conclusion that lower fed fund rates will be there for a long period.

These things have clearly confirmed the hikes that are being priced by the market are incorrect.

so what next in terms of trading with in rates space. Expect a clear range bound market with falling volatilities in the front end. Long term rates have some room to rise but they will fall in the medium term.

tomorrow i will post some trades. BTW, i have been playing with IBM condor and so far this trade has done well (as of today it has made 1000 dollars profit).

Good Night
Chandra Khandrika

Economic thoughts

Public mood towards economic thought prevailing today is that economists, central bankers and regulators failed to see the crisis coming. Majority group started questioning the theories propounded and practiced in diagnosing the problems. Among economists we see people talking down Keynes and his followers who have prescribed government has to save the sick economy by providing adequate antibiotics of stimulus. On contrary they claim that irrationally predictable human behavior is cause of these problems and new set of tools and theories needs to be developed. In my perspective, neither Keynes is wrong nor was his predecessors wrong. There is an old proverb everyone is right from their own point. Each economic thought has two messages. First message belongs to the time when this theory was developed and second message gives a timeless message that is applicable to all time periods.
To understand modern day economic thought it is imperative that we understand how various people have left their long lasting impressions on this field. People like, Adam Smith, David Ricardo, Joseph Schrumpter, Alfred Marshall, Jeremy Bentham, Keynes, Milton friedman, efficient market theorists and behavioural finance economists. Although this list is not exhaustive but it would be apt to say that these folks have contributed towards the development of economic thought that we are witnessing today.
Smith came up with invisible hand theory in 1776 with the publication of Wealth of nations and became to be known as father of Capitalism. But Capitalism existed since the dawn of human civilization. Capitalism is not an object that needs to be discovered. Smith when started observing how people from various trades cooperate seamlessly to produce goods for mutual economic prosperity. This idea serves under all times and eras. But crooked human behavior can mercilessly subject some humans to appalling working conditions of production of goods for making profits. This makes people like Karl Marx to propound radical thoughts and make capitalism as an evil. We should not forget, in the long run only two regimes, democracy and capitalism prevails on the surviving living beings on the planet earth. David Ricardo came up with his theory of comparative advantage trade theory for mutual prosperity. As times have changed, global trade increased, industrialization has matured in western countries we have witnessed prosperity only to be punctuated by great depression of 1929. Economists have observed this crisis and its consequences and Keynes prescribed that government should bend over knees to support the economy by providing stimulus and central bank should become ultimate liquidity provider. Later on Milton friedman came up with his theory of monetarism stating that due to political nature. In late 70’s economic thought already loaded with shades of smith, Keynes, friedman evolved into a new direction in the hands of efficient market theorists. This has lead to development of fascinating derivative structures as chief risk transferring tools. Global trade machine has seen a gush of liquidity and wheels started moving at full speed. This machine came to a grinding halt when subprime crisis took hold. Behavioral economists have sensed now it is their time to rise to the occasion and prescribe solutions. This group says irrational exuberance displayed by people towards the appreciation of housing prices has caused the problems that we are seeing. To support their claim Shiller and akerlof came with their book animal spirits. Are they right? There is no one answer. Current crisis has clearly showed that we have not learnt enough in understanding the functional mechanism of capitalism. We have a long way to go and theories to date have failed and behavioural finance is trying to take a role onto itself to explain the problem. Will they succeed? Next crisis will tell that