A market options hedge as other risks lurking out there despite Tuesday's rally

CNBC

27-05-2025

Bond yields provide critical insights into economic expectations, inflation, and currency valuation. Higher bond yields, especially on government bonds, can signal expectations of stronger economic growth. Lower yields suggest economic slowdown or recession fears, as investors flock to safe assets, driving bond prices up and yields down. Higher economic growth is good, but higher inflation is not, and yields also incorporate inflation forecasts. Higher yields may also indicate rising inflation expectations, as investors demand compensation for eroding purchasing power. In theory, investors can distinguish whether yields are increasing due to better economic expectations or worse inflation expectations by observing the spread between nominal yields and inflation-protected securities (TIPS), which reflects breakeven inflation rates, or at least inflation as measured by CPI-U . Consumers generally favor a stronger currency, which increases their purchasing power of imported goods. Domestic producers and exporters favor a weaker currency, whose goods will be more competitive. Higher domestic yields, all else equal, elevate the local currency's value. 'Carry trade' risk For instance, if U.S. 10-year yields rise relative to German bunds or Japanese bonds, the dollar may strengthen against the euro or yen. Lower yields reduce a currency's appeal, potentially weakening it against other currencies, especially if other central banks offer higher rates. These yield differentials are key drivers in carry trades. A narrowing yield differential between U.S. and foreign bonds often pressures the dollar, and potentially other dollar-denominated risk assets. In early 2024, the spread between Japanese and U.S. Treasury rates began to narrow, falling by ~130 basis points from more than 4% to less than 2.8%. (1 basis point equals 0.01%.) This prompted concerns about substantial deleveraging as investors worried about an unwinding of the yen carry trade. A drop in U.S. rates propelled that swing, but Japanese government bond yields have recently risen sharply. This is problematic because it might pressure the carry trade if Japanese rates rise more quickly than US rates, and the amounts involved are substantial. Japan is even more indebted than the U.S. due to the size of its economy, roughly 250% of Japan's GDP, with total government debt of approximately $8 trillion. If the spread does not compress, then that suggests U.S. Treasury rates would also rise, which could pressure other risk assets. If Japanese rates continue to increase, this presents a global risk. The S & P 500 has clawed back more than 70% of its peak-to-trough losses from the all-time highs in February, and the Cboe Volatility Index (VIX) , although elevated, is well off the April peak. For these reasons, I think re-initiating hedges might be advisable. For example, a June 30th (month-ending) SPDR S & P 500 ETF Trust (SPY) 575/525 put spread ($50 wide) cost ~ $8.90 per contract or just over 1.5% of the current share price of the ETF, and less than 18% of the difference between the strikes, offering a payoff of better than 4.5:1. The trade: Buy SPY June 30 $575 put Sell SPY June 30 $525 put DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL'S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.