Simple Math On A Measly 25 Basis Points

| About: SPDR S&P (SPY)

Summary

Interest rates are Ice Age Rating for us. They've never been here.

That means a small spike can wag the bond dog much bigger than if rates were higher.

Bill Gross points out simple math magnifying unbalanced risk/reward of bonds which implies stock market risk.

We've made this point many times to say that January's market drop was thanks to a teensy weensy 25bp Fed change.

Here's what Bloomberg just reported about Bill Gross:

Gross, who built the world's biggest bond fund at Pimco and is now at Denver-based Janus Capital Group Inc., reiterated his warning that rock-bottom yields mean bonds are especially vulnerable because a small increase in yield can bring a large decline in price.

You think Mr. Gross knows? We know he knows. He's the world's best-known bond investor.

Let's get right to the simple math of what he's talking about.

What would a measly little 25bp uptick in bond yields mean for principal amounts (you know, the paper you hold on to when owning a bond)? You'd think not much right?

Here's the math of a normal bond period and a measly 25bp move.

Bond Price Yield Coupon
1000 5.25% 52.5
954.5 5.50% 52.5
-45.5 hit
-4.5% hit not so bad

If bonds start at $1,000 face value with a coupon of 52.5 they yield 5.25%. Fair? Let's say the yields go up a measly 25bp. It's not so much, right? The coupon would stay the same of course but the bond price would drop $45.5 or 4.5%. 4.5%, not so bad right?

A 25bp move in the market would drop this bond's principal value 4.5%.

Let's look at the same measly 25bp move of a bond yielding .25%, you know like many of the bonds being bought by CBs (Central Banks) hand over fist.

Let's see if it looks any different to today's bond market.

Bond Price Yield Coupon
1000 0.25% 2.5
500 0.50% 2.5
-500 hit
-50.0% ouch

Let's start in this totally pretend, never ever could in our millennium happen, not to us, not with QE-million, but just for fun let's look at the numbers.

If we started with a bond yielding 25bp on that $1000 face value it would mean the coupon was $2.5. Let's just for fun (of course this could never ever in a million centuries happen in the bond market ever never no how no way bulls, ATH, love, up to infinity) see what would happen if that 25bp turned to be 50bp.

You, please do the math at home on that coupon to see if we are just way off (which very well could be). Please we strongly urge you. (How many reports that you read in your life strongly urged you to check their numbers? Nobody right? That's worth following through on a once in a lifetime interactive author's request. Please do the math and see for yourself.)

The math is Coupon divided by yield gives you price. Coupon/Yield = Price

This is how we see it. $1000 bond with a $2.5 coupon each year yields .25%. If market yields then went to 50bp that would mean that the $2.5 coupon bond would now trade at (Oh, c'mon Elazar you are too bearish, that could never happen, math doesn't work anymore we are beyond math, what me worry, c'mon already, enough with these ridiculous articles) $500.

That $1000 bond that just issued a $2.5 coupon and the yields jumped a measly 25bp would turn into a $500 bond. That is a material $500 hit.

That is a -50% principal return for a measly market jump of 25bp.

Does that deserve the Ouch Rating? You decide.

We said that this was the reason for Q1's crash. Fed rates went up a measly 25bp.

Here's the Famous Ice-Age Prehistoric Fed Funds Rating chart.

The above chart shows Fed Funds futures in never ever land. That teeny weeny uptick on the right side caused markets to crash in January.

Let's see what the Fed move on December 16th did to markets in January after everybody returned from vacation.

We marked this chart (NYSEARCA:SPY) with all the pertinent timing of events to know that a measly 25bp rate hike was really a 50% rate jump from 25 to 50bp. That caused a stock market spill.

This is the type of thing we've been talking about for a couple of months. This is what Bill Gross pointed out.

ECB just said the same thing as Gross. The ECB?

The Financial Times just reported that a senior ECB official has been repeating a warning that "lenders would be hit hard if interest rates remain low and long [and then] skyrocket."

Hmm.

The FT went on to report that, "The [very bearish, mean ol': Elazar added the hard parenthesis] hawkish central banker has long cautioned that any small change in interest rates risks triggering an abrupt reversal in global markets."

Wait a minute. Did you catch that? In the same article the mean 'ol hawkish ECB banker said "skyrocket" but he also said "any small change" to describe the same turn of events. Which is it?

"Skyrocket"....IS "any small change!"

C'mon mean 'ol bearish hawky CB official, that could never happen. That would require rates to skyrocket like you say.

We'd like to Elazarize what skyrocket means.... You already did the math: Skyrocketing means any small change or numerically..."A MEASLY 25 BPS."

Ouch, maybe that isn't so unrealistic.

Conclusion

Mean ol' central bankers and mean 'ol Bill Gross are at it again talking about strange things like risk and jumps in rates and terrible risk reward scenarios. Those crazy risk/reward scenarios would happen based on a measly tiny little antsy mousy 25bps. Never ever in a million years could it happen, right Elazar? Wrong.

We hope that the day or week that sees "any small change" of a "skyrocketing" measly 25bp in interest rates everybody was already in cash or hedged. Could that ever happen? C'mon. Definitely it could.

Please be safe.

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Disclaimer: All investments have many risks and can lose principal in the short and long term. This article is for information purposes only. By reading this you agree, understand and accept that you take upon yourself all responsibility for all of your investment decisions and to do your own work and hold Chaim Siegel, Elazar Advisors, LLC, bestideas, their related parties, and its authors harmless.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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