One of the big questions for the financial markets as we head into the next decade is where are interest rates going as we kick off a new year. On one hand, the labor market is strong and stock prices are at all-time highs. On the other hand, many other economic indicators are showing a slowing of the economy and the average person is still holding too much debt.
This week, the Fed meets for their final FOMC meeting of the year. According to the futures market, there’s a 98% chance they hold rates steady. The language in the Fed statement also isn’t expected to change much.
The central bank is still likely to point to the strong labor market as a reason for not lowering rates any further. It’s also probably way too early to talk about raising rates after the Fed just got through with a cycle of rate cuts.
So what about next year? Is there any evidence that the Fed will remain steady in its rate outlook in the near future?
One trade I came across in the options market could give some clues about rate expectations next year. This trade was a large covered call position established in iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). LQD is an extremely popular ETF which tracks investment grade corporate bonds.
The trade itself was comprised of 750,000 shares of LQD versus 7,500 January calls. The shares were purchased for $127.60, while the January 128 strike calls were sold for $0.65. That means nearly $500,000 was collected in premium.
In terms of yield, the trade generates a half percent in just over a month. Now that may not seem like a lot, but there are a few things to consider. First off, LQD is a very low volatility ETF, so options premium are low. What’s more, if you annualize this trade, it works out to almost 6% on the year, which isn’t bad in an ultra-low rate environment.
Furthermore, LQD does pay a $0.35 dividend during the period of this trade. Since the dividend will be collected by the trader (the shares were purchased as part of the trade), that raises the yield of this trade to 0.8%.
Because the calls were sold at the 128 strike, the trade can also earn another $0.40 of stock appreciation. Meanwhile, the $0.65 collected from the calls provides some decent downside cushion through January expiration (down to $126.95).
Once again, this ETF doesn’t move all that much over the short-term. As you can see from the chart, the entire range for the stock price since October is roughly $125.50 to $128. This is definitely a low volatility instrument.
A covered call like this one is neutral in its outlook. There is some upside potential built in, along with some downside cushion. Whoever made this trade doesn’t expect a lot to happen with corporate bonds in the next month.
Of course, corporate bonds are heavily influenced by the Fed Funds rate. This suggests the Fed is going to stay neutral on rates at the start of 2020, as we expect. This trade would also be an easy thing for you to emulate in your portfolio, especially if you already hold LQD for your portfolio’s corporate bond exposure.