Executive summary

While some anticipate continued volatility and higher yields in the 10-Year Treasury market, others anticipate macro-economic conditions will help stabilize long-term yields.  Rich examines 10-Year T-Note option strategies for either market view.    

  • Risk reversal for bearish outlook
  • Calendar spread for bullish outlook

During the Spring in the Midwest, we know there are chances of tornadoes because the dominant wind pattern goes from the cold, dry air from Canada to the warm, moist air from the Gulf of Mexico. When the warm, moist air is lower near the ground and it swirls with the cool, dry air above, the conditions for a tornado appear.

Right now, we may be seeing that in the markets. The cool, dry air that has been with the markets all year long, providing a chill that has lasted longer than normal, is the macro headwinds the market is facing. The combination of central bank hawkishness, the war in Europe, China COVID lockdowns and global rising costs for basic needs has put a chill on the appetite for risk-taking.

The warm, moist air we are feeling, tells us maybe the worst is behind us and we can look forward to better ‘weather’ for the markets and the earnings coming through better than expected. The economy drives earnings and earnings drive stocks. We are about 20% through earnings season and companies in every sector have reported. In aggregate, earnings are better than expected, indicating better times could be ahead.

However, we are at that point where the air could be mixing, which means the conditions are ripe for a tornado. The chart in Figure 1 shows a measure for risk in major asset classes - implied volatility. The risk in 'macro' assets of foreign exchange (purple) & U.S. Treasuries (white) is moving higher, telling the markets that we are not out of the woods yet. There are still problems occurring in the world. There is still a war in Europe, both the 10-year bond and Japanese Yen have broken out of 35-year channels, moving into parts unknown. This is all potentially destabilizing. The risk in 'idiosyncratic' asset classes of equities (blue) & credit (orange) are back to the lows, telling us it is time to put away that winter gear and enjoy what is ahead.

Figure 1: Implied Volatility of major asset classes

If we dig in specifically to the 10-year yield, we can see the cross-currents continue to play out. The Federal Reserve has a dual mandate – full employment and price stability. Thus, the Fed cares about both growth and inflation. The 10-year yield is just a sum of the expected future Fed Funds rates plus some term premia. One way to look at it is that the 10-year yield is telling us what the market thinks about changes in Fed policy as a result of both growth and inflation. In the chart below, you can see that for the better part of this century, inflation has been stuck in a band. As a result, changes in the 10-year or collective views on changes in Fed policy have been more responsive to change in growth, which I show here as the year-over-year change in the U.S. ISM. That is until recently. The 10-year was following the changes in the ISM until the CPI decided to move above the highest levels than what we have seen in 30 years. The 10-year market is now faced with having conflicting opinions on growth and inflation. Conflicting views mean uncertainty and the potential for volatility.

Figure 2: ISM, CPI and 10-Year yields

The 10-year U.S. Treasury market is a global market too. It is not just U.S. investors that are faced with this potential new regime. According to the U.S. Department of the Treasury, about 33% of foreign-owned U.S. debt belongs to Japan and China.

Figure 3: Foreign owned U.S. debt

Lately, both the Chinese Yuan and the Japanese Yen have been in meaningful weakening patterns. China’s Yuan is a managed float, so the volatility is not high relative to other currencies. However, the signaling may be more powerful potentially as this may be seen as a conscious decision by the Chinese authorities to weaken the Yuan.  The Bank of Japan announced it is continuing to peg the 10-year Japanese Government Bond yield to 0%, essentially inviting a weakening of its currency. In a sense, Japan is inviting the inflation that is plaguing so many other countries to come to Japan. Weaker currencies lead to higher potential inflation. Given its demographic trend to an older population, Japanese authorities have been trying for decades to stoke inflation, with the Three Arrows policy of Prime Minister Abe in 2013-2014, the latest aggressive gambit. However, this latest move is the first time the Yen has broken out of a 35-year trend toward a stronger Yen. Weaker currencies in the countries of the largest holders of U.S. debt make future debt purchases look less appealing. Thus, it may not be a complete surprise that U.S. yields have moved higher.

Figure 4: 10-Year yields, Yen and Yuan

Pulling this all together, with so many drivers of yield pushing prices into new territory, combined with investor uncertainty and several potential catalysts, the market has responded by moving implied volatility prices to the highest we have seen this year.

Figure 5: YTD U.S. Treasury CVOL

Though stepping back, these same volatility prices don’t appear as elevated. In particular, the 10-year yield CME Group Volatility Index (CVOL) price is really only in the middle of the range when we look at all of the price data. We can’t ignore that prices are elevated on a YTD basis, but given that yields are moving into regions we don’t normally see, we can’t lose sight of the longer-term boundaries of implied volatility either.

Figure 6: All time U.S. Treasury CVOL

So, it comes down to one’s views on the 10-year yield. Some think of yields and consider the 35+ year channel that has dominated the market for most of people’s entire career. Yes, we have moved above that channel right now, but we saw a similar head fake in 2018. This camp would suggest that demographics, debt, and disruption will bring yields back lower. This means that an aging developed economy population lowers potential growth as most consumers naturally spend less as they move into retirement.  In addition, the excess of debt on developed economy balance sheet also lowers potential growth because excess debt crowds are out spending on capital goods and investment in the future. Finally, disruption, mainly globalization and technology disruption, has lowered the cost for goods around the world and mean prices will stay low and keep long-term yields in check.

Figure 7: 10-Year yield multi-year

Though, there is another camp. This camp will counter the points above by saying that emigration from parts of the world that are seeing turbulence into developed markets economies, is changing the spending in those economies and therefore the potential growth.  This camp would also suggest that we are potentially past the point of peak globalization, and instead are seeing companies looking to rationalize supply chains by building manufacturing closer to where it’s sold. This is done to have redundant sources of supply (with trade wars, pandemics and supply chain issues the last few years) and in order to be focused on the environment and on all stakeholders – not just shareholders but customers, communities and employees. Finally, the excess debt argument is countered by suggesting we are potentially embarking on Modern Monetary Theory type policies of debt issuance and spending growth. This theory suggests that reserve currency countries issue debt to invest until that point when we see inflation, which is the markets way of saying the debt amount has finally gotten too large. This camp has been bullish on yields (bearish on bonds) for over a year.

Figure 8: 10-Year yield weekly

Pulling this all together, one can make a case for continued volatility and higher yields, or for longer-term trends to reassert, a move back into the range, and volatility to come back from the highs of the year. I am not here to tell you which camp you should be in. I know that there are large and vocal players on both sides of this argument as I engage with them on social media platforms each day. There are famous bond fund managers that are cautioning against the risk of higher yields, and equally well-known hedge fund managers that suggest this is the buying opportunity of the year. I won’t tell you who to believe, but what I will try to do is give you one idea to express either view.

For Bond bears

You foresee lower bond prices and higher yields. This most likely coincides with higher implied volatility as we remain in parts unknown, above the 35-year trading channel, driven by waning interest from Japanese and Chinese investors that are seeing their buying power for global assets suffer as their currency weakens. If you are wrong, and bond prices move higher, the view would be that implied volatility probably moves lower as well.

Looking at the 25 delta risk reversal volatility differences, it’s somewhat surprising to see the differential relatively flat and not outside the bonds of what we have seen the last 14 years.

Figure 9: 10-Year T-Note Risk Reversal history

Personally, I would have expected higher volatilities for the bond puts relative to the bond calls given all the different drivers. Therefore, one trade example is to buy the June 118 put and sell the June 121.50 call. This trade is essentially zero cost (a small premium is earned) and the volatility differential is also very small.  There is mark to market risk on this idea. However, at expiration, there is no payout between 118 or 121.50. The position would lose if prices are above 121.50 on a 1-to-1 basis. This corresponds to approximately 2.58%. Yet, if the view is correct, and Treasury Yields continue into uncharted territory and bond prices continue to fall, the position will benefit on a 1-to-1 basis below 118 at expiration.

Figure 10: 10-Year T-Note Risk Reversal

For Bond bulls:

You are a bond bull. This has served you well for 20+ years in the market. Yes, you are under a bit more selling volume now versus the rest of your career. However, you know it’s just a matter of time before normalcy resumes. Growth will slow and pull inflation down with it. This is the base case scenario of the Fed. This is the base case scenario for blue-chip consensus economists. This is your base case scenario, too. We are already seeing signs of a housing bubble that may suffer under the weight of mortgage rates that have gone up over 60% this year. We are seeing commodity prices pullback as the market grows aware of the COVID lockdown in China and what that means for global growth. These types of moves have happened before and may happen again. The best plan is to wait until prices are oversold and buy into it. In addition, implied volatility is at the highs of the year but equity volatility and credit spreads are not, suggesting something must give here.  As a result, one may find a trade that allows the position to benefit directionally from a move higher in prices, but also from a move lower in implied volatility. The catalyst may likely be the next FOMC meeting on May 4.

To do this, a trader buys three of the June 121.50 calls and sells two of the August 121.50 calls. Yes, one is buying a slightly higher implied volatility.  However, shorter dated options are much more driven by gamma and realized volatility moves than by vega and implied volatility moves. The resulting position is long gamma, for all the potential catalysts that could happen, but short vega, for a move back into the range and volatilities to settle down from the YTD highs.

Figure 11: 10-Year T-Note Calendar spread

The position is also taking in premium net. That means if the opinion is completely wrong and bond prices move a lot lower over the next month, the position still has some profit as is shown on the left side of the chart in Figure 12.  The best-case scenario for the spread is a large move higher in the near term that is combined with lower implied volatility in the long term. Of course, nothing is without risk. The longer it takes for a move higher to happen, the faster the long options will decay as the theta is much larger and the position is longer June options. It is an instant gratification example, premised on a catalyst coming with Fed meetings and potentially oversold conditions. If the market gets no move before June expiration, the position will still be short August calls. If bonds have moved lower in the interim, the trader would be able to cover those at lower prices. Hopefully not spending all the initial premium received. If prices remain at current levels or higher, but not through the strike and implied volatility does not come lower, this would be the worst-case scenario. The beauty of options – traders have to get the direction AND the timing correct. However, if they do, there is a good deal of potential leverage to your idea.

Figure 12: 10-Year T-Note Calendar spread expected return

All eyes are on the 10-Year Treasury market. This market is the gold standard of all asset classes because it’s the rate from which we can and do price every other asset class - from other sovereign bonds, to credit instruments, to FX forwards, to commodity futures and to equity multiples. The direction of the 10-year matters to everyone. It is in this uncertainty that one can often find the best opportunities.  Finally, while I focus on options strategies, CME Group has a new product to trade – Micro 10-Year Yield Futures. Volume is gaining traction and the trading size fits most portfolios. This is a ‘delta 1’ product as I say but can also more cleanly fit your bullish or bearish view. The beauty of derivatives markets – there is something for everyone.  Happy trading.

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