Treasury Bears Seeking Sanctuary May Find Relief in Option Skews

  • U.S. fiscal expectations crumble as markets await reality
  • Short-dated option skews in swaps richen for lower rates

Investors caught out by the recent rally in Treasuries may find some solace in option skews.

The cost of options to bet that U.S. yields will fall in the near term has now moved higher than those to position for an increase. With volatility beyond three-month expiries still relatively low, this boosts the appeal of hedging against mounting geopolitical risks via spread options.

Short-dated skews on 10-year rates have turned negative, with receivers trading at a premium to payers. The flattening of short-dated skews increases the attractiveness to hedge against lower rates via receiver spreads.

These skews tend to predict subsequent changes in underlying rates, with flatter skews since December having indicated risks to duration shorts.

U.S. rates optionality to position for an unwind of recent pessimism in the belly of the curve also becomes attractive as the skew flattens and implied volatility on six-month expiries remains relatively low. Investors may scale into out-the-money payers with the risks related to French elections likely to persist and on any further geopolitical escalation from North Korea and Russia. Payer skews may subsequently richen on the removal of the weight on the market surrounding these political risks.

Investors who initiated straddles at the end of March as implied volatility fell to a post-U.S. election low, amid an unwind of reflation trades, may start to focus on delta hedging by paying swaps.

Last month: Treasury Bears on Reflation Train Face Peaking Price Pressures

Intermediate and long-term Treasury yields have broken down from this year’s ranges and are now at their post-election lows, given the confluence of global political-risk events and increased doubts about the prospects for sizable tax reform. Investors need to quantify how much of President Donald Trump’s policy agenda is left in the price and the risks if policy disappoints.

The negotiations over tax reform will likely last for months and the market may react negatively if corporate-tax reform is delayed until 2018 or fails. The failure of the health-care bill may accelerate the timing of tax legislation.

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

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