Here's What Could Happen as Complacency Runs Rampant

We have been noting a strong correlation between stocks and crude oil. Now that oil is showing signs of topping out, it feels like a correction in the S&P 500 is likely on the horizon. We have seen few meaningful corrections in stocks since the financial crisis, although one could argue the March 2020 pullback should count as two because of the shock and awe it caused, albeit temporarily. Yet, the majority of notable pullbacks in the stock market have been preceded by sharp selling in oil. In 2020, oil broke a month before stocks did, so there can be a delayed reaction. The Treasury market has been able to rally sharply in the face of higher stocks and non-believers, but imagine what the short squeeze might be capable of if some of the froth and complacency works its way out of the equity market. Thus far, buying in the 30-year bond and 10-year note has been impressive, but it hasn't become emotional. We suspect, with complacency running rampant, that could change quickly. Further, a breach of resistance in the 10-year note futures contract near 134 and the 30-year bond near 164, would likely cause the buying to have a feeling of panic to it. (Note that on the chart those points are noted as 134'0 and 164'0 -- the par value of the bond/note prices of the 10-year note futures contract and 30-year bond futures contract.) As a result, we could see a 1% yield on the benchmark 10-year. Chart Source: QST We have noticed a change in market behavior; Treasuries, gold, and the U.S. dollar have all managed to grind higher together. This isn't something we always see. In fact, gold and the dollar usually move inversely to one another. In our view, we believe this might be a hint of what is to come as the summer progresses. In other words, at least some market participants (although not most) are quietly seeking safety. That said, the uptick in the dollar and Treasuries suggests at least some of the bond and note buying could be from overseas investors. This shouldn't be shocking -- yields overseas are dramatically lower for debt securities with higher risk. We don't think the Treasury rally is over. Seasonality is supportive, interest rate differentials continue to be supportive, and speculators seem to have been caught off-guard leaving the door open for more short squeezing. Further, the equity market is (arguably) overvalued, if investors ever opt to rebalance or reallocate, things could get wild. That said, we could see prices relax temporarily before resuming the trend. A low cost way to speculate on further upside potential without much downside risk (in exchange for deep OTM upside risk) is a call option ladder. Hypothetical Trade Here's a hypothetical trading idea for educational purposes. If you do not understand this strategy or the risk/reward prospects, do not attempt to trade it, and instead, consult your broker or paper trade the idea: September 30-year Bond Futures Options Buy one September 30-year Bond 164 call at 2'00 ($2,000) Sell one September 30-year Bond 167 call at 1'00 ($1,000) Sell one September 30-year Bond 170 call at 0'32 ($500) Total Cost = 0'32 ticks ($500) Risk = Below 164'0, the risk is limited to what is paid for the option spread ($500). Because the trade involves one long call and two short calls, there is unlimited risk above the breakeven point (about $172.50). For reference, the market is currently near 163'0. Above the breakeven point, it would be like being short a naked futures contract. Reward = If the 30-year bond futures contract is between 167'0 and 170'0 at expiration in 51 days on August 27th the trade pays off $2,500. Margin = $1,184 DTE = 51 (Aug. 27) Remember, there is a substantial risk of loss in trading commodity futures and options.

Here's What Could Happen as Complacency Runs Rampant

A change in market behavior is in action as oil appears to top out and Treasuries, gold, and the U.S. dollar have all managed to grind higher together.

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