Putting Bonds On Warning?

| July 31, 2012 | 0 Comments

There’s no question that the market continues a tight tug of war between risk aversion and risk appetite.

On one hand, the bulls stress the value of equities and oppose the extreme levels of negativity toward them.  By almost every measure, they’re cheap relative to the alternatives.

On the other hand, we’ve all heard the equity doom mongers who obsess over the unending problems in Europe and the dampening effects it’s had on the US economy.

So, what’s the right position to take, stocks or bonds?

I’ve been a firm believer that equities are a much better place to park money over the long term than Treasuries.

In addition, there’ve also been technical reasons to like the S&P 500, including the way it has bounced several times at its 50-day moving average.  And is now even above it.

Here’s the kicker…

What’s more, there’s another problem emerging.  One which no one else to my knowledge has yet cited as a danger, the risk that Treasury yields will break key long-term support and fall to new lows.

Now, given that stocks and bonds usually move in opposite directions, a new flood of money into Treasuries could unexpectedly hammer the S&P 500.

I know it sounds unusual, but something similar happened in mid-2008, when stock traders ignored ominous signals in bonds.

The difference was then it was the mortgage market, today it is Treasuries.

But wait, there’s more.

Let me say this… Central bankers have been very busy meeting and scratching their heads, trying to support unsustainable fiscal structures in Europe.

What’s wrong with this is that throughout the whole process, they’ve remained confident that “liquidity” and low interest rates are the cure all.

What they haven’t seriously considered is…

What if the policy measures themselves are making the patient sicker?  What if keeping borrowing costs near zero have created a perverse incentive to own Treasuries?  What if the medicine intended to revive the animal spirits is now putting them to sleep?

My worry is that everyone is ignoring the yield curve.  The yield curve is simply the difference between short-and long-term interest rates.

It’s currently too wide, and contraction could be painful for equities.

I guess it’s equities then.

Between 1977 and 2007, 30-year Treasuries yielded about 1.1 percentage points more than two-year notes.  That differential shot up to 4 percentage points by mid-2010 after the Fed pushed short-term rates down near zero.

And it’s narrowed even more since investors continue to chase yields at “the long end of the curve,” 30-year bonds.

Right now the spread stands at about 2.3%, still well above the long-term average.   A similar situation is true for the 10-year note versus the two-year.

Bottom line… What’s this all mean for investors?

Usually the yield curve flattens when the Fed raises rates. But that possibility is off the table thanks to Ben Bernanke’s own statements.

So the only way for us to return to average or “normal” levels is for 30-year yields to drop even further.  However, this would have a profound negative effect on stocks. 

I’m not ready to sound the alarm on equities yet. 

I believe they’re still the better place to be over bonds.

But I am wary.  I’m keeping a close eye on those Treasury-bond yields.   If rates do go much lower, it could be bad news for the stocks.

I’ll continue to use put options to hedge my long stocks so I can remain in the game no matter what.

Safe Trading,

Marcus Haber

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Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.

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