Long-term Treasuries are poised to rally as the skew in option volatility reached the lowest since 2011, signaling wagers for higher yields have become overdone, according to Bank of America Corp.
Positioning for higher Treasury yields amid signs of an improving labor market and rising inflation has spurred hedging of those bets through purchases of options that profit if rates fall, causing the so-called skew to fall, Bank of America analysts said. Short positions, or bets yields will rise, have held even as Federal Reserve policy makers said after its June 18 meeting that it will keep the benchmark interest rate at almost zero for a “considerable time” after its bond-buying program ends, likely later this year.
“The sharp flattening of the skew over the last six months may signal a build-up of, and now crowded, short positions,” said Ruslan Bikbov, a fixed-income strategist in New York at Bank of America, said in a telephone interview. “Investors establishing these core short positions are hedging those bets with options. And history shows a decline in the skew has been a significant predictor of lower yields.”
Benchmark 10-year Treasury note yields fell four basis points, or 0.04 percentage point, to 2.57 percent at 11:18 a.m. New York time, according to Bloomberg Bond Trader data. The yield reached 2.69 percent on July 3, the highest level since May 2.
The difference between volatility, a gauge of price and demand, on three-month options that allow investors to lock-in paying fixed rates on 10-year swaps and those that grant the right to receive fixed rates, has fallen to 4.7 basis points, or 0.047 percentage point, from 14 in December, according to Bank of America data. The so-called swaptions skew, which is at the lowest since December 2011, tends to narrows as demand increases for hedges against lower rates.
The skew, which compares volatility on payer and receiver swaptions, is analogous to a risk reversal in currency options, which compare puts with calls. A payer swaptions allows an investor to lock in paying fixed rates, while receivers grant the ability to receive fixed rates. A put allows an investors to sell a currency, while a call allows for purchases.
Swaptions are options on interest-rate swaps. In most swaps, two parties agree to exchange fixed for floating interest-rate payments during a period of time with the floating rate typically based on changes in the London interbank offered rate, or Libor. Swap rates usually mirror movements in Treasury yields.
The number of contracts hedge funds and other large speculators hold betting on a decline in 10-year notes outnumbers those counting on gain, according to Commodity Futures Trading Commission data as of July 1. The so-called net short position for 10-year notes, at 69,358 contracts, has held since August 2013. Net shorts peaked during the past year in November at 189,188.
Investors have been speculating that the Fed will raise borrowing costs next year after the government reported last week that U.S. employers added 288,000 workers in June, compared with the 215,000 projected by a Bloomberg News survey of economists. The consumer price index rose 2.1 percent in May above the level a year ago, the biggest jump since October 2012, another report showed June 17.
Traders see a better than 70 percent chance that officials will raise the key rate target from near zero by September 2015, fed funds futures contracts show.
“The short view is the consensus view right now,” said Bikbov. “We can see that in portfolio managers’ surveys, to speculative futures positions and our own internal surveys. That has a very important implication for the market, and investors should be cautious establishing new shorts here.”