Volatility Seen in Treasuries as Traders See Higher Yields
U.S. government debt is becoming increasingly perilous to options traders who are pushing up the cost to protect against sudden losses by the most in a year, even as Federal Reserve stimulus suppresses volatility.
The cost to lock in fixed-interest rates that are a half-percentage point above 10-year yields is now about 17 percent higher than contracts tied to prevailing rates, according to data compiled by Deutsche Bank AG. The premium for the three-month options has risen from this year’s low of 10 percent in June, signaling growing demand for protection from the risk U.S. borrowing costs will start rising before March. The increase was the biggest since 2012.
While the prospect the Fed will keep its $85 billion of monthly bond purchases into 2014 caused swings in 10-year Treasury yields (USGG10YR) to diminish and encouraged bullish options traders to bet on lower rates, the relative calm is obscuring the danger that investors may get blindsided by a pullback. Some speculators are hedging their bets that yields are poised to eclipse 3 percent. Reports on jobs, services and manufacturing last week all showed U.S. companies persevered through the partial government shutdown.
“There is a nervous stasis in the market,” William O’Donnell, the head U.S. government bond strategist at RBS Securities Inc. in Stamford, Connecticut, said in a telephone interview on Nov. 5. Investors are signaling that “yields could easily be a long way away from here given there are a daisy chain of market risks to come between now and about March. It keeps alive this tail-risk hedging.”
Yields on 10-year Treasuries touched 2.79 percent today, the highest level seen since they surged in September to a two-year high of 3.01 percent. Yields fell as low as 2.47 percent last month after the Fed surprised forecasters in September by maintaining the pace of quantitative easing and the 16-day government shutdown that ended Oct. 17 threatened to weaken the nation’s recovery.
U.S. debt with maturities longer than 10 years slid 11 percent this year, the largest drop among 144 indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies.
As speculation shifted from how soon the Fed will start tapering to how long it may wait, economists in a Bloomberg survey on Nov. 8 said the central bank will keep suppressing borrowing costs by buying $45 billion of Treasuries and $40 billion of mortgage-backed debt each month until March. At the same time, bond investors have become more convinced borrowing costs will remain steady.
Fluctuations for 10-year Treasury yields decreased to the lowest since June 2011 at the end of October, based on historical 30-day volatility, a measure of the actual pace of rate swings.
Since reaching the year’s high of 50.6 percent in July, the gauge tumbled to a low of 20.9 on Oct. 30, according to data compiled by Bloomberg. Volatility has averaged 39.5 over the past five years, the data show.
The lack of apprehension in the debt markets has unnerved some traders in U.S. interest-rate swaps, who are driving up demand for options that will protect them from sudden fluctuations over the next three months.
“You have a build-up of risks,” Aleksandar Kocic, an interest-rate strategist at Deutsche Bank, said in a telephone interview on Nov. 4. “The market has driven itself to this position where it’s going to be very painful if rates move. The Fed will likely be the main agent for this.”
When Fed Chairman Ben S. Bernanke signaled in May that the central bank could taper its stimulus in “the next few meetings” if the U.S. posted sustained growth, Treasuries swooned and yields on 10-year notes surged by more than a percentage point in 3 1/2 months.
Volatility for three-month contracts that enable investors to pay a fixed rate that is 0.5 percentage point above the 10-year yield is 1.17 times greater than contracts struck closest to current yields. Volatility is used to gauge the cost of options.
While demand for contracts that profit from falling rates has also increased, the bearish wagers on the options reflect expectations that U.S. borrowing costs will rise higher than most interest-rate strategists and economists project as the recovery gains enough momentum.
Ten-year Treasury yields rose the most in two months last week, climbing 0.13 percentage point to 2.75 percent, Bloomberg Bond Trader prices show. The price of the 2.5 percent note due August 2023 fell 1 2/32, or $10.63 per $1,000 face amount, to 97 28/32.
Yields on the notes will reach 2.94 percent in the first quarter of 2014, according to the weighted average estimate in a Bloomberg survey.
American companies are already shaking off the effects of the federal shutdown more quickly than economists anticipated.
Employers added 204,000 workers in October, exceeding all 91 forecasts in a Bloomberg survey, Labor Department figures showed on Nov. 8. The median projection was for a 120,000 gain.
The payroll data came three days after the Institute for Supply Management’s non-manufacturing index rose, indicating hiring in the services industries picked up in October as the biggest part of the economy unexpectedly expanded.
U.S. manufacturing also accelerated last month to the highest level since April 2011, surprising economists who forecast a contraction, as U.S. producers of everything from textiles to cars benefited from a boost in domestic demand.
While the shutdown probably pared growth to an annualized rate of 2 percent this quarter, the economy is likely to expand by 2.6 percent next year, a full percentage point more than for 2013, based on a survey of 75 economists on Oct. 31.
By 2015, growth is projected to accelerate to 3 percent, which would be the fastest pace in a decade.
“The underlying economic reality is the economy has made a lot of progress,” Zach Pandl, a Minneapolis-based senior interest-rate strategist at Columbia Management Investment Advisers, which oversees $340 billion, said in a telephone interview on Nov. 7. “We are not in the same sort of world we were in a year or two ago. Given that the economy continues to improve, taper is inevitable.”
The case for sustained growth in the world’s largest economy still isn’t strong enough to warrant a pullback from the Fed, which will keep short-term borrowing costs from rising, according to Mohamed El-Erian, chief executive officer and co-chief investment officer at Pacific Investment Management Co., the world’s biggest bond fund manager.
While a government report last week showed the U.S. grew more than economists estimated in the third quarter, consumer spending climbed at the slowest pace since 2011 and business purchases on equipment weakened. Consumer confidence in the week ended Nov. 3 dropped to a one-year low, with the Bloomberg Consumer Comfort Index falling for a sixth straight week.
Employment and inflation have also fallen short of the central bank’s goals. The jobless rate in October rose to 7.3 percent -- above the 6.5 percent level the Fed said would prompt policy makers to consider raising short-term rates.
The Fed’s preferred gauge of inflation, the personal consumption expenditures price index, increased 0.9 percent in September from a year earlier and has remained below its 2 percent target, adopted in January 2012, for 17 straight months.
When yields on 10-year Treasuries surpassed 3 percent in September as indicators such as falling weekly claims for jobless benefits and rising manufacturing orders suggested the economy was strengthening enough to allow the Fed to pare its bond purchases, the central bank maintained that it didn’t have the evidence to justify paring its stimulus. That was before the budget impasse triggered the shutdown and pushed the country toward the first default in its history.
U.S. benchmark lending rates “are going to stay low for a long time,” El-Erian, whose firm oversees $1.97 trillion, said in a Bloomberg Television interview on Nov. 8.
Slow growth and an accommodative Fed “lasts as long as the other policy-making entities don’t get their acts together,” he said. El-Erian said Newport Beach, California-based Pimco recommends that investors purchase Treasuries with maturities of five years or less.
Some measures indicate that investors are underestimating the risk of financing the U.S. government.
With the amount of outstanding U.S. debt more than doubling since mid-2008 to an unprecedented $11.6 trillion as the U.S. financed deficits to mitigate the fallout from the financial crisis, potential losses due to rising yields on the longest-maturity Treasuries are close to the highest since at least 1996, according to Bank of America Merrill Lynch index data.
The gauge known as duration, which calculates how much prices change when yields rise or fall, for Treasuries due in 10 years or more is at 15.8, closing in on the all-time high of 16.6 in May.
Volatility in three-month options on 10-year yields struck at rates closest to current levels has fallen at about twice the pace of the drop in Treasury yields since September, signaling some options traders may be overestimating how long the Fed will maintain the pace of its bond buying, said Ruslan Bikbov, a fixed-income strategist at Bank of America Corp.
“A tapering of bond purchase is going to be volatile when it happens,” he said in a telephone interview on Nov. 7 from New York. “While better-than-expected data in the next couple of months may trigger an out-sized move higher in rates.”
At its Oct. 29-30 meeting, the Fed refrained from providing stronger signals of prolonged stimulus in a statement after signaling diminishing concern over higher borrowing costs as they maintained the pace of bond purchases.
The cost to protect against a 10 percent loss in the longest-dated Treasuries was 1.29 times greater last week than options that profit from a 10 percent gain, based on the implied volatility of three-month contracts on the iShares 20+ Year Treasury Bond ETF, an exchange-traded fund.
That’s the biggest premium since the aftermath of the Lehman Brothers Holdings Inc. bankruptcy in September 2008.
With yields close to historical lows, “you have elevated interest-rate risk, because they could turn around and go higher,” said Carl Kaufman, the San Francisco-based co-manager of the $5.2 billion Osterweis Strategic Income Fund (OSTIX), which has outperformed 95 percent of its rivals in the past three years. “Very small changes in the economic outlook or rates cause big changes in the markets, which exaggerates moves.”
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