Is Mean Reversion Looming for Bonds?

by Tyler Craig | August 28, 2013 1:55 pm

Is Mean Reversion Looming for Bonds?

Bernanke’s mid-May tapering remarks threw a wrench into the bond-stock correlation, clogging up the gears of what was previously a reliable relationship.

Since the old market peak in 2007, stocks and bonds have consistently moved in opposite directions; one zigged, and the other zagged. Stocks — along with the euro, oil and a few other assets — sit in the risk-on camp. In contrast, bonds pal around with the greenback and gold in the risk-off camp.

In statistical terms, they’ve had a negative correlation — and a decisively strong one at that.

And yet, that’s all changed in the past few months. The rapid rise in interest rates has toppled both bonds and stocks, flipping their relationship from negative to positive. These abnormal conditions have lifted the 20-day correlation up to +0.81 — its highest level since 2007.

BondsStocks Is Mean Reversion Looming for Bonds?
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Rather than betting that Wall Street has permanently entered some parallel universe where stocks and bonds move in lockstep, it’s altogether more likely that the unusually strong positive link between equities and fixed income is an aberration that will, in the end, prove transitory. Once the rapid reaction to the Fed’s policy shift plays out and interest rates settle down, bonds should return to their stable ways for a spell.

In fact, we’ve seen such a return to normalcy over the past three trading sessions with bonds and stocks moving in opposite directions.

While three days does not a trend make, it is comforting — for bond bulls at least — that U.S. Treasuries still possess their safe-haven status, catching a bid in times of market turmoil.

Given how much interest rates have already rallied, it’s certainly worth pondering how much of the Fed’s taper has already been baked into the cake. 10-year Treasury yields are up some 74% since May — a move made all the more impressive when you consider it from a standard deviation perspective (see chart below).

StdDev Is Mean Reversion Looming for Bonds?[1]

10yearyield Is Mean Reversion Looming for Bonds?
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No doubt, contrarians are viewing the extremity of the rise in rates with thoughts of mean reversion dancing in their heads. If your inner contrarian shouts out and you’re looking for rates to fall (and bond prices to rise) over the next month, consider selling put spreads in the iShares 20-year Treasury Bond ETF (TLT[2]).

Sell the Oct 100 put and buy the Oct 95 put for a net credit of 62 cents or better. The max reward is limited to the initial 62-cent credit and will be captured if TLT remains above $100 by October expiration. The max risk is limited to the distance between strikes minus the net credit, or $4.38, and will be incurred if TLT falls below $95 by expiration.

To minimize the risk, consider exiting if TLT falls beneath the short strike of $100.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2013/08/StdDev.jpg
  2. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT

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