Treasury Bulls Eye Long Term After Yellen’s Rate Pledge

Options traders making bullish bets on U.S. Treasuries are looking far into the future as they weigh Federal Reserve Chair Janet Yellen’s pledge to keep interest rates low.

Investors are paying the most since July 2012 to bet that U.S. government bonds maturing in two decades or more will rally, according to data compiled by Bloomberg. The iShares 20+ Year Treasury Bond ETF rallied 11 percent in the first half of the year.

Traders concerned that the central bank’s first rate cut will send bonds with shorter maturities higher are speculating longer ones will do better as sub-par growth fails to spur inflation, Grant Peterkin of Lombard Odier Asset Management said. In its most recent forecasts, the Fed cut its long-term projections for economic expansion and and interest rates.

“The market effectively repriced as long-term growth and rates expectations were lowered,” Peterkin, who helps manage the 205 million-euro ($280 million) Absolute Return Bond Fund, said by phone from Geneva on June 25. “Whether we get a positive short-term growth surprise, or a negative long-term growth shock, longer-dated bonds will outperform.”

New Projections

Traders are looking beyond the debate among Fed policy makers on how long to keep the benchmark rate near zero after the bond-buying program ends. Markets rallied around the world after the central bank lowered its long-term interest-rate forecast to 3.75 percent on June 18 from a prediction of 4 percent in March. The Fed projected long-term economic growth of 2.1 percent to 2.3 percent, compared with 2.2 percent to 2.3 percent seen three months earlier.

The Bloomberg U.S. Treasury Bond Index, which tracks securities maturing in more than 12 months, climbed 0.4 percent last week, its biggest weekly increase since May. The benchmark 10-year yield dropped to an 11-month low that month and lost 48 basis points to 2.53 percent in the first half, Bloomberg Bond Trader data showed.

Bullish options calling for a 10 percent increase in the Treasury ETF cost 0.72 point more than bearish bets pricing in a 10 percent decline on June 23, according to three-month implied volatility data compiled by Bloomberg. The last time investors paid this much for bullish contracts relative to bearish ones was almost two years ago. In November, calls were 3.83 points cheaper than puts, the widest gap since March 2009.

Investor Complacency

Although longer-dated Treasuries may now be more attractive than shorter ones, the cost of protecting against losses is low across tenures. This signals the risk of investor complacency that will backfire should the Fed raise rates earlier or at a faster pace than projected, according to Alessandro Bee, a strategist at Bank J Safra Sarasin AG.

A measure of protection costs for Treasuries dropped for three consecutive months, even as the Fed reduced the pace of its monthly asset purchases to $35 billion from a record $85 billion. Bank of America Merrill Lynch’s MOVE Index, based on prices of over-the-counter options on the debt maturing in two to 30 years, fell to its lowest level since May 2013 this week. It climbed 2.3 percent to 59.58 yesterday.

“What worries me is that markets are more focused on what the economy will do in a few years and have reduced the focus on what it’s doing right now,” Bee said by phone from Zurich on June 27. “The U.S. economy is really improving and most indicators point to a more hawkish Fed stance. There might be an unpleasant surprise for markets in the next months, especially with volatility so low.”

Policy Timing

James Bullard, the Fed Bank of St. Louis president, said last week that interest rates may rise by March, after the central bank’s officials predicted that the benchmark rate will be 1.13 percent at the end of 2015 and 2.5 percent a year later, higher than they previously forecast. Even so, economists surveyed by Bloomberg call for an increase only in the second quarter.

Traders are sticking to their bets. Three of the five most-owned Treasury ETF options were bullish, data compiled by Bloomberg show. Short interest on the Treasury ETF has dropped to 25 percent of shares outstanding from a peak of 46 percent in January, according to data by research firm Markit.

“It’s going to be a long path from here to normal, and the idea is to try to predict what the base will be towards normalization and what it will look like after the immediate crisis,” said Dirk Thiels, head of investment management at KBC Asset Management NV in Brussels. “The Fed is expressing confidence in the economy but saying there is still a lot of vulnerability that requires it to be more accommodative. Low growth and low rates looks like the Goldilocks scenario.”

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