Rates volatility skew shows bond yields in Europe and the U.S. could decline from record lows. Deep out-of-the-money swaptions remain flat, indicating no turnaround is imminent, Bloomberg strategist Tanvir Sandhu writes.

During last year’s bund tantrum, the spread between out-of-the-money payer and receiver volatilities proved to be a leading indicator of the direction of bond yields.

The spread ticked lower before the yields reversed course from near zero during that period, described by Janus Capital Group Inc.’s Bill Gross as “short of a lifetime”.

Bund scarcity

In Europe, scarcity of bunds eligible for the European Central Bank’s quantitative easing purchases are driving yields further down amid the disinflationary backdrop.

German bonds maturing up to and including May 2024 yield less than the ECB’s deposit rate of minus 40 basis points, disqualifying them for purchases.

Short-tail EUR gamma may be boosted in anticipation of ECB revisions to QE parameters, which is required for the ECB to extend purchases beyond current end-date of March 2017.

Inflation markets show very little inflation risk premia with forward inflation swaps showing ECB inflation target of 2 percent may not be reached even in 50 years.

In the U.S., better-than-expected June non-farm payrolls has not drastically changed dovish Federal Reserve repricing, with U.S. overnight index swap not fully pricing in a 25 basis points rate increase until at least 2018, which may lead to acceleration of steepening in the swaptions grid.

Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.

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