August 3rd, 2023
Where’s The Recession? Bond Market Insights
Last week the Fed decided to hike rates once more, adding 25 basis points to bring the Fed Funds rate to 5.50%. In the past 10 rate hikes, the Fed has always given us a heads-up, but this time, it’s not so clear what’s in store for future rate increases. Chairman Powell was determined to keep rates above 5%, always emphasizing the “higher for longer” approach. Now that we’ve reached this point, it’s become a mystery as to what the future holds. Perhaps the bond market has some insights to offer.
We’ve all seen the charts and read the stories about the inverted yield curve that just won’t come back above 0.0. As many have written about, including me, the inverted yield curve has been a predictor of future recessions months after the yield curve inverts.
Typically, in regular market conditions, longer-term bonds offer higher yields because investors seek greater returns for lending their money over extended periods.
However, there’s an inversion in the yield curve when short-term yields surpass long-term yields. The prevailing explanation for this phenomenon is that bond traders anticipate the Federal Reserve cutting interest rates in response to an impending recession.
But now with so much positive economic data showing that inflation is coming under control, one is left to ask, what happened to the recession?
Maybe we will look back at the Silicon Valley Bank crisis and say that the inverted yield curve predicted the “recession”, but thanks to the Fed’s response of providing liquidity to the banks, we avoided a full-blown recession.
Or maybe there may be a downturn coming as consumers run through their extra savings.
Either way, I think the bond market will revert to the mean (in this case move higher). The likelihood is that the 2-year and 10-year will converge in 2024 when the Fed looks to cut interest rates.
If you believe the 2-year yield will decrease (revert to the mean), I have an ETF for you. The iShares 1-3 Year Treasury Bond ETF (SHY) is an inverted ETF,, meaning that it will rise in price as the short-term yield decreases.
If you agree with this theory, this might be a good opportunity for a poor person’s covered call strategy. Rather than buying 100 shares and selling monthly calls against that position, we can simulate something similar by purchasing a long-dated call option instead of shares, and then selling covered calls against that option.
For example, I can go out to the Jun 2024 $81 call and buy it for around $2.35 and sell the 18 Aug 23 $82 option for about $0.10. While that may not seem like much credit, a $10 credit reduces the cost basis by about 4%. If you can pick up $10 over the next 5 options expiration cycles leading up to 18 Jun 24, you’ve reduced your cost basis by 21%, let alone what profit you may have from the long-dated option.
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Editor, Filthy Rich Dirt Poor
Coach, Options Testing Lab
Any trade or trade idea discussed is for educational purposes only. They will not be tracked as an official trade recommendation.