Will Bond Traders Finally Release Their Death-Grip on Bonds?

Dear SlingShot Trader Subscriber,

The FOMC gave stocks a big boost yesterday with very positive comments (relatively speaking) about the economic recovery in the United States and a lower likelihood for additional easing in the short term. Banks were up higher at one point, although the stress-test results yesterday evening stalled that rally. Bonds took a dive inverse to the rise in stocks, which can be considered an important technical signal.

The relationship between bonds, yields, and stocks is something we have written about many times in the past. In normal market conditions, the interaction between these markets is an important investment tool. We are not in normal market conditions right now, because the Fed is still the largest market participant and has been artificially intervening in the bond market at unprecedented levels since late 2008.

Would you buy a stock that was majority owned by its own management team?

We will leave the argument about whether this is good or bad in the long term alone for now, however, we can say that this intervention will lead to increased levels of volatility in the short term. Imagine that you were evaluating a stock that was controlled by a management team that also had controlling interest as a shareholder (such stocks are rare but there are a few of them). This is very similar to the bond market right now, with the Treasury/Fed management team actively modifying the supply and demand for Treasury bonds on a day to day basis.

This can have unintentional ripple effects across the market by artificially propping up bond prices and reducing volume in the stock market. However, not even the Fed is big enough to control the market forever. For example, in the next chart you can see an index of the yield (inverse of bond prices) of the 10-year Treasury bond. If inflation were running at normal historical levels over 2%, the real yield on these bonds would have been below 0% for most of the last six months. The market broke out of this artificial range yesterday and could continue to climb for the next few weeks.

Bond fund investors hate inflation + growth

Inflation has been creeping just above historically “normal” levels again recently, which means bond investors should get itchy to sell again as yields rise. Although we have literally never seen yields this low, we know what happens when inflation or the expectation of inflation starts to kick up again. This happened after the recession ended in 2003, and led to an extremely sharp correction in bonds in 2009 when the Fed was pumping money into the market with a fire hose.

chart1
10 Year Treasury Bond Yield Index (TNX): Chart Courtesy of MetaStock

 

This is going to be a big week for bonds, and despite all the intervention by the Fed/Treasury, it could turn out to be a big breakout for stocks too.

First, traders seem more confident that the economy is doing “OK,” courtesy of the Fed’s announcement on Tuesday. That will drive some traders out of safe-havens like bonds and into stocks with better growth prospects.

Second, the Treasury is auctioning new 30-year bonds today, which have already seen a small dip in ready buyers. If the yield in long-term bonds has to rise to complete the auction, stocks are likely to benefit from another selling round by bond investors looking to take profits.

How we are taking advantage of this breakout as news traders

This is a great week to make a news-based play on bonds. Besides the two factors we mentioned above, we get inflation data this week. PPI and CPI price data are released on Thursday and Friday respectively, and price-growth has been creeping back up to “normal” levels lately. This could actually make bond investors very nervous.

All that money the Fed has been pumping into the economy could increase inflation levels unexpectedly, which is very bad for bond prices. Usually in a growth environment, rising inflation is good for stocks, which should also be good for us as call-option buyers.

Although our major economic-worries are far from over, we think this is a good time to take advantage of the potential decline in bonds and the upcoming inflation data. Earlier today we sent an alert to open a trade on TLT puts. This bond fund is one of the biggest in the market and holds bonds with 20 years to maturity or more. This fund will be extremely sensitive to changes in inflation or expectations that inflation may rise in the near term. We don’t expect to hold the trade for very long, but it may be one that we revisit again in the coming weeks.

This Week’s Events

Here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.

Mar. 15 – Treasury International Capital Flows

Mar. 15 – Manufacturing reports (Empire & Philly)

Mar. 15 – PPI Inflation numbers

Mar. 15 – Ross Stores (ROST) Quarterly Earnings

Mar. 16 – CPI Inflation numbers

Mar. 19 – Adobe (ADBE) Quarterly Earnings

Mar. 21 – Chinese manufacturing data (HSBC PMI)

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via e-mail. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here. You can also see more trade-specific details by clicking on the trade links below.

Open Positions

These are the SlingShot Trader positions we opened during the past week of trading that we have not yet closed.

Bank of America (BAC) — On March 13, we recommended you to “buy to open” the April 9 calls for $0.22 or less. We still like this trade but the price is too high for new entries. If you are currently holding the position, hold for now and enjoy the gains.

iShares 20+ Treasury Bond Fund (TLT) – On March 14 we recommended you to “buy to open” the April 111 puts for $2.00 or less. We still like this trade and recommend entries at our maximum price or less.

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

Ralph Lauren (RL) — On March 13, we recommended you “sell to close” the April 180 Calls. We closed the position for $5.02 for a gain of 14%.

Ann (ANN) — On March 9, we recommended you “sell to close” the April 25 Puts. We closed the position for $0.50 for a loss of 67%.

KB Homes (KBH) – On March 9, we recommended you “sell to close” the April 12 calls. We closed the position for $1.02 for a gain of 29%.

American Eagle Outfitters (AEO) – On March 7, we recommended you “sell to close” the April 15 calls. We closed the position for $1.05 for a 57% gain.

Webinar Preview: Join Us Tonight at 6 p.m. ET

Every Wednesday at 6 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you’ll have live access to us for an hour every week.

And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at johnandwade@slingshot-trader.com.

If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.

Sincerely,

 

John Jagerson and Wade Hansen
Editors
SlingShot Trader