BAML: Investors are still getting one key thing wrong about the market

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REUTERS/Lucas Jackson

  • Bank of America Merrill Lynch says traders are continuing to misprice how quickly rates are going to rise.
  • The firm recommends going long the US dollar and hedging against stock declines in the face of higher interest rates.

 

Investors are underestimating how quickly the economy is growing. At least that’s what Bank of America Merrill Lynch says with regards to interest rate expectations.

The firm notes that while the US rates market has repriced in recent months, it’s still unprepared for what it thinks will be the pace of rate increases over the next year or so. It also trails median forecasts from the Fed’s so-called dot plot, which summarizes rate forecasts from the members of the Federal Open Market Committee.

“Stronger growth is causing markets to reprice US rate expectations to the upside,” BAML investment strategist James Barty wrote in a client note. “Yet expectations remain well below the dot plot. We think further adjustment is needed, pushing yields and the USD higher into year end.”

Bank of America Merrill Lynch

The end of Barty’s quote touches upon one of BAML’s recommendations for playing this wrinkle in the market. The firm says to expect strength in the US dollar, which should also get a boost from corporate tax reform and the likely repatriation of billions of dollars from overseas. The greenback has rallied slightly from a multi-year low reached earlier this year, but it’s still nowhere near recent highs.

From a stocks perspective, BAML has an idea how to purchase protection. It suggests that traders buy so-called “fragility hedges” using options contracts. The firm specifically recommends shorting one S&P 500 put contract on the benchmark falling to 2,300 by June for every two put contracts bet long on the index to hit 2,500 by the end of December. The equity benchmark closed at 2,587.84 on Friday.

BAML explained the attractiveness of the entry point comes from the steepness of the S&P 500’s term structure, where near-dated contracts are expensive relative to those further in the future. Further, put skew — or the degree to which future protection is more expensive than at-the-money options — is high because of the market’s tendency to buy more stock exposure on short-term dips.

You can see that dynamic at play in the chart below.

So now you know what to do to prepare yourself for higher rates in the future: go long the US dollar and buy some downside stock protection.

Bank of America Merrill Lynch

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