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Option Decline Signals Treasury Market Ready for Fed Tapering

Options are signaling that the Federal Reserve can reduce its bond-purchase program without causing a spike in price swings in the Treasury market.

Three-month implied volatility on 10-year interest-rate swaps dropped to a one-month low of 89.4 basis points from 122.6 basis points on July 5, which was the highest since 2011, according to data compiled by Bloomberg. The gauge is a measure of projected yield fluctuations over the next 90 days. Half of the economists surveyed by Bloomberg said the Fed will begin trimming its $85 billion in monthly bond purchases in September. The U.S. plans to sell $35 billion of two-year notes today.

“The market is calming down,” said Ali Jalai, a Treasury trader in Singapore at Scotiabank, a unit of Canada’s Bank of Nova Scotia (BNS), one of the 21 primary dealers that trade directly with the Fed. “The market has accepted that tapering is different than tightening. In the next six months to a year, all we’re getting is tapering, we’re not getting tightening.”

Benchmark 10-year yields were little changed today at 2.48 percent as of 1:50 p.m. in Tokyo, Bloomberg Bond Trader data showed. The 1.75 percent note due May 2023 traded at 93 22/32. The yield has fallen from 2.75 percent on July 8, which was the highest level since August 2011.

The next target for yields is 2.415 percent, which was this month’s low, George Davis, chief technical analyst at RBC Dominion Securities Inc. in Toronto, wrote in a report yesterday.

Japan’s 10-year yield slid 1 1/2 basis points to 0.77 percent, a level not seen in 10 weeks. A basis point is 0.01 percentage point.

Treasury Losses

Treasuries have fallen 2.2 percent this year, while Japan’s sovereign debt returned 0.7 percent, based on the Bloomberg World Bond Indexes.

The MSCI All-Country World Index of shares returned 13 percent including reinvested dividends.

An index measuring Treasuries’ 10-day price volatility dropped to 2.44 percent yesterday from 7.49 percent on July 8, which was the highest in 20 months.

The Merrill Lynch Option Volatility Estimate Move Index fell to 72.62 basis points yesterday, the lowest level in almost two months. The figure is down from 117.89 basis points on July 5, which was the most since December 2010. The one-year average is 64.71.

None of the 54 economists surveyed July 18-22 predicted the Federal Open Market Committee will begin paring its $85 billion of monthly purchases at its meeting scheduled for July 30-31.

Monthly Buying

In its first reduction, the FOMC will probably cut monthly bond buying to $65 billion. Economists see purchases divided between $35 billion in Treasuries and $30 billion in mortgage-backed securities, according to the median estimate.

The Fed has kept its target for overnight bank lending in a range of zero to 0.25 percent since December 2008. It has said it will consider raising the target when the unemployment rate falls to 6.5 percent, versus 7.6 percent as of June.

Investors shouldn’t be complacent about a reduced Fed purchase program, according to Tomohisa Fujiki, an interest-rate strategist in Tokyo at BNP Paribas SA, another primary dealer. BNP expects the Fed to start tapering in December, he said.

“There are still potential risks that may cause a big move in the market,” Fujiki said. “Once the Fed starts tapering, volatility is more likely to pick up.”

Housing Market

Ten-year yields were close to the lowest level in two weeks yesterday as an industry report showed purchases of existing homes fell 1.2 percent to a 5.08 million annual rate. The median forecast of economists surveyed by Bloomberg News was a 5.26 million pace. New home sales probably rose for a fourth month in June, based on a separate survey before the Commerce Department issues the figure tomorrow.

Treasury trading volume at ICAP Plc, the largest inter-dealer broker of U.S. government debt, was $194 billion. It fell to 184.3 billion on July 19, which was the lowest level since April.

The two-year securities scheduled for sale today yielded 0.325 percent in pre-auction trading, compared with 0.43 percent the last time the notes were sold on June 25.

Demand weakened at the previous two offerings of the notes. The bid-to-cover ratios, which gauge demand by comparing the amount bid with the amount offered, at the June and May auctions were 3.05 and 3.04, the two lowest since February 2011, Treasury data show.

Direct bidders, investors and dealers outside of the primary-dealer network bidding directly to the Treasury, won 7.8 percent of the June offering, the least since April 2012. Indirect bidders, the group that includes foreign central banks, bought 35.8 percent of the debt, the most since February.

The U.S. is also scheduled to sell $35 billion of five-year debt tomorrow and $29 billion of seven-year securities July 25. It auctions this combination of securities every month.

To contact the reporter on this story: Wes Goodman in Singapore at wgoodman@bloomberg.net; Masaki Kondo in Singapore at mkondo3@bloomberg.net.

To contact the editor responsible for this story: Rocky Swift at rswift5@bloomberg.net

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