Rate Increase Creates Risk for Both Bond and Equity Buyers

Long-term U.S. bonds continue to be in demand, even in the face of a potential increase in interest rates. Duration, which measures a bond's price sensitivity to interest rate changes, is higher for longer-term bonds, suggesting that buyers could be in for a big surprise if the Federal Reserve proceeds with the rate increase. See article here, WSJ. At the same time, equity markets fell with the renewed expectation of a rate increase. See article here, WSJ.

Yield Curve Flattens

The spread between short- and long-term government bonds has decreased, creating a so-called flatter yield curve. This move has been driven by two factors. First, there is an increased belief that the Federal Reserve will raise interest rates, which has driven up the yields on shorter-term bonds. Second, foreign buyers have been acquiring longer-term U.S. bonds as they have a higher yield than their home country offers. This has pushed down the yield of longer term bonds, creating the flatter yield curve. See article here, WSJ.

Synthetic Mortgage Backed Security

Put-Call Parity describes an equality relationship that must exist across call and put options on a given security, assuming the same expiration date and exercise price. Given this relationship, traders are able to create "synthetic" positions. Such positions allow investors to mimic the payoffs of an actual position in the underlying investment. Recently, the lack of available liquidity in CMBS (commercial mortgage backed securities) has led investors to create synthetic positions in these assets. See article here, Reuters.

Short Interest at High Levels

Short interest has been high even though the market has recovered significantly. In fact, in the wake of the recovery, short sellers have increased their positions. If they are correct, we could see a market pullback. Their short positions, however, create a large "sideline" demand, which has actually made market moves more positive in the wake of neutral news (due to short covering). See article here, Yahoo/Bloomberg.

China Looks to Add Credit Default Swaps

Credit Default Swaps (CDSs) enable investors to hedge the risk of bond (or other credit securities) default. Like any derivative, they essentially allow investors to transfer risk -- from hedgers to speculators (or even between hedgers or speculators with different exposures). See article here, Reuters.

Income and Spending

Normally higher incomes lead to higher spending, but recent increases in income seem to be headed into savings. This creates a mixed picture for consumer stocks. See article here, LA Times.

Conflict of Interest in 401(k) Funds

Companies often hire third party administrators (TPAs) to manage their respective 401(k) plans. Some companies simply provide documentation and advice; however, other TPAs actually offer their own proprietary (in-house) funds as investment alternatives. New research (see Journal of Financial Research) shows that these funds often carry higher fees and have lower returns, illustrating the impact of a conflict of interest. This is particularly pronounced for banks and insurance companies acting as TPAs.