This U.S. Treasuries 'Breakout Play' Has Rarely Been So CheapBy
Rally in stocks and bonds calls for a more cautious approach
Risks of market correction are rising but yet to be irrational
The low cost to hedge a break-out from the range in long-term rates may appeal to investors seeking hedges for a more measured portfolio stance.
Strangles on the iShares 20+ Year Treasury Bond ETF, which seeks to track the returns of an index of U.S. Treasury bonds with maturities greater than 20 years, are near all-time lows.
The realized volatility of long-term rates has moved lower this year as the hopes of U.S. President Donald Trump’s policies sparking reflation have crumbled. Inflation break-evens have fallen to pre-Trump levels following downward surprises to core inflation and the decline in oil prices, while financial conditions are still seen as supportive of growth.
The probability of a spike in risk aversion is increasing as equity markets and economic expectations have rarely been so far apart, with the Federal Reserve now seemingly concerned about asset-price bubbles given its hawkish tone even as the U.S. economy is losing momentum.
A regime shift in volatility could be best captured with long-convexity exposure combined with tactical shorts rather than tail-risk strategies betting on mean-reverting volatility spikes.
- 6-month TLT 35-delta strangles are currently priced at about 3.6 percent, near all-time cheapness, providing low-cost way to hedge a break-out of the range in long-term rates
- TLT and IEF implied volatilities have collapsed across the term structure with 3-month implieds near record lows
- TLT 6-month implied volatility is trading 120 basis points below realized, lowest since 2015
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.