Betting on Fed Disappointment? Exotic Derivatives Do Just That
(Bloomberg) -- A dovish Federal Reserve may be boosting bonds and giving a fillip to stocks, but UBS Group AG is dangling a strategy for traders to wager the honeymoon won’t last.
It’s pitching an exotic derivative that pays out 10-to-1 if Treasury yields at epic lows rise by a modest clip -- and disrupt the equity rally in their wake.
With fierce conviction in markets that the Fed will embark on an easing cycle this year, the bar for the next bond-driven tantrum in risk assets has been lowered, the thinking goes.
All that’s spurring structuring desks on Wall Street to offer hedge funds and institutional investors fresh ways to speculate on the fraught relationship between the world’s largest bond and equity markets.
“Three rate cuts are now baked in by year-end, which is quite a high hurdle for the Fed to meet, let alone outperform,” Pete Clarke, global head of equity derivatives strategy at UBS, said in an interview in London. “There’s definitely a risk that they end up easing by less than what’s expected, exacerbating the downside risks for equities in the process.”
The UBS weapon of choice is multi-asset derivatives that pay out 10 times the outlay, if a rise in the 10-year swap rate is accompanied by a modest drop in the S&P 500. What’s striking is how little bonds and stocks need to move for the investing style to pay off handsomely.
Under a recent indicative trade pitched by the Swiss investment bank to clients, the 10-year rate has to rise to a mere 2.34%, around 23 basis points from current levels, while stocks trade just 1% lower than current levels by September.
Rising yields have famously proved enemy number one for equity investors time and time again in this bull market. See it as paranoia that tighter monetary policy risks killing the business cycle, or that higher borrowing costs will hit corporate treasurers and equity valuations.
Monetary officials told investors Tuesday last week they’re watching closely for signs that growing trade tensions are clouding the outlook for the world’s largest economy. After the remarks, the S&P 500 jumped the most since January while Treasuries rallied.
Whether a less-dovish-than-expected monetary stance will spur a rise in the 10-year rate is open to debate. There’s a case longer-dated yields could edge lower if investors figure the outlook for growth and inflation is weaker. Meanwhile, higher yields on the back of stronger data could also indicate stronger corporate earnings, a boon for equity investors.
Still, the UBS trade centers on modest cross-asset gyrations and the Fed rules market psychology right now. Futures reflected more than 70 basis points of easing in 2019 at one point on Wednesday last week, showing traders have concluded that the case for rate cuts is only strengthening -- suggesting any disappointment could spark a backlash in risk assets.
“There’s a correlation discount in playing S&P down with rates up -- since they’ve previously tended to move together,” said Clarke. “Entry levels look good right now -- the S&P is back closer to highs, whereas the 10-year dollar swap rate is down 125 basis points since the fourth quarter of last year -- approaching 2017 lows.”
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