Options traders are paying record prices to protect against swings in long-term U.S. Treasuries relative to stocks amid concern inflation will accelerate.
Implied volatility, the key gauge of options prices, for contracts with an exercise level closest to the iShares Barclays 20+ Year Treasury Bond Fund (TLT) has climbed to 16.65, compared with 13.85 for the SPDR S&P 500 ETF Trust (SPY), according to three-month data compiled by Bloomberg. The ratio between the two ETFs reached 1.24 on Sept. 14, the highest since at least 2005.
The Treasuries fund, which includes bonds maturing in 20 years or more, fell the most since July 2009 last week, while U.S. equities rallied after the Federal Reserve pledged to keep monetary policy accommodative even when the economy strengthens, increasing inflation concerns. The Fed’s preferred measure of the market’s expectation of price increases has risen to 2.8 percent, near the highest in 13 months.
“Treasuries don’t offer a whole lot of value here,” Bret Barker, a portfolio manager at Los Angeles-based TCW Group Inc., which manages about $128 billion, said in a Sept. 18 phone interview. “The Fed is going to be in ease mode even longer than the market expected, and as such inflation expectations are rising. The open-ended purchasing caught the market off guard.”
The central bank said last week that it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month, without a limit on the total or duration. The Fed also extended its near-zero interest rate policy until 2015 to support economic growth and bring down an unemployment rate stuck above 8 percent since February 2009.
The announcement prompted investors to reduce bearish bets for stocks. The cost of puts on the U.S. equity benchmark fell to the cheapest level in more than three years relative to calls on Sept. 14, data compiled by Bloomberg show.
More bearish options on the Treasuries ETF traded than bullish ones last week. Puts on the bond fund changed hands an average of 80 percent more than calls last week, the biggest weekly volume gap in almost a month, the data show.
The Fed’s favored bond-market gauge of inflation expectations increased to 2.8 percent on Sept. 18, above the central bank’s 2 percent goal. The five-year, five-year forward break-even rate shows how much traders anticipate consumer prices will rise during a period of five years starting in 2017.
The cost of living in the U.S. climbed in August by the most in more than three years, reflecting a surge in fuel costs. The 0.6 increase in the consumer-price index was the biggest since June 2009 and followed no change in the previous month, the Labor Department reported on Sept. 14.
“Effectively what the Fed has said is, ‘We are going to buy whatever we need to buy in order to ensure economic growth,’” Wayne Lin, a money manager at Baltimore-based Legg Mason Inc., said on Sept. 19 by phone. His firm oversees $636 billion. “That kind of puts a floor on the equity market.”
The Treasury fund has returned 34 percent, compared with an 86 percent rally in the S&P 500 ETF since Nov. 25, 2008, when the Fed committed as much as $800 billion to help resuscitate lending.
Treasuries may still be an attractive investment in a low- growth environment, according to Wasif Latif, vice president of equity investments at USAA Investments in San Antonio. Hedge funds and large speculators have raised bullish positions in 10- year Treasury notes to the highest since March 2008, according to data compiled by Bloomberg.
U.S. government securities are hovering at the most expensive levels ever, according to a model created by economists at the Fed that includes expectations for interest rates, growth and inflation. The 10-year term premium was negative 0.86 percent yesterday and reached a record low of negative 1.02 percent on July 24.
A negative reading indicates investors are willing to accept yields below what’s considered fair value.
“We’re not living in an environment where people are buying Treasuries for the yield,” Latif said in an interview at Bloomberg’s headquarters in New York on Sept. 19. His firm oversees about $50 billion. “From a yield perspective, Treasuries are overpriced, but from a safety perspective, where else are people going to go?”
Bank of America Corp. Merrill Lynch’s MOVE Index, which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, rose 3.8 percent to 59.70 yesterday. The Chicago Board Options Exchange Volatility Index, or VIX (VIX), as the benchmark gauge for S&P 500 equity derivative prices is known, climbed 1.4 percent to 14.07. Europe’s VStoxx Index, which measures the cost of Euro Stoxx 50 Index option prices, fell 3.4 percent to 19.43 at 9:51 a.m. in Frankfurt today.
The ratio of outstanding puts to sell the Treasury fund versus calls to buy increased 4.6 percent since its Aug. 16 low to 1.7-to-1 on Sept. 18, data compiled by Bloomberg show. Among the 10 most-owned options, eight were bearish, and October $122 puts had the largest open interest, the data show.
“Investors right now are greatly underestimating the risk in U.S. bonds,” Stephen Smith, lead fund manager at Brandywine Global Investment Management, which oversees $40 billion of debt, said at a discussion in New York hosted by American Beacon Advisors on Sept. 19. “The recovery is still weak, but we are growing, and the reality is: the downside in U.S. debt is much worse than the upside.”
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