Treasuries-Bund Trade Is About to Get Interesting

In recent years, many investors have been burned by their conviction that the price of German bonds would fall relative to U.S. Treasuries of the same maturity, as the yield on the 10-year bund dipped for the first time into negative territory. But with the return of consistent growth and a reduction in near-term political risk in the euro zone, options prices indicate that interest rates are more likely to increase than decrease in Europe’s largest economy. This is a significant departure from a number of months ago, when options market prices were neutral as to the direction of rates in Germany.

Options market signals indicate that yields on 10-year Treasuries are likely range bound and therefore the premium investors earn by holding U.S. bonds over their German counterparts is likely to fall as yields on the latter rise. Options function like insurance, with their prices providing efficient estimates of the market’s assessment of the larger upside and downside risk of possible near-term outcomes. Most is gained by ignoring small possible changes -- the noise -- and by focusing on what is expected to be material.