Executive summary

In his latest report, Rich Excell looks at market expectations and future catalysts such as Fed meetings, Treasury issuance, and economic data, which may make long optionality a compelling trade in the coming month.

Lately, bond traders are getting hit by a slew of cross-currents. The market appears to have exited the Peak Fed period, with traders anticipating minimal FOMC actions. Meanwhile, after the debt-ceiling agreement, the Treasury has increased issuance to replenish the Treasury General Account. Lastly, headlines like the Fitch downgrade arise, prompting us to reconsider long-term trends and our current position.

The fiscal spending that is leading to a worsening deficit is a major focus of Fitch, an important talking point for the party out of power, and perhaps a big reason why we may experience a soft-landing. 

A recent article from Reuters discussed how the Treasury will have to grow coupon auction sizes—not just in August but through the end of this year and into early next year–to account for the imbalance between supply and demand. Additionally, Bills issuance might soon reach its limit, and certain maturities such as seven or 20 years lack liquidity. This means the more liquid parts of the curve may have to absorb a larger than normal share of this issuance.

With this in mind, traders were intently focused on the report from the Treasury Borrowing Advisory Committee to the Secretary of the Treasury that came out in early August. This report went into detail about the debt ceiling debate, the bank crisis, the Federal Reserve Senior Loan Officer Survey, and foreign demand for Treasuries. It also discussed the increased need for borrowing due to the expanded fiscal deficits.

The report provided quantifiable data, indicating that Treasury’s issuance requirements are projected to be around $1 trillion in Q4. This figure surpasses the May refunding amount due to anticipated increased receipts and decreased outlays. This issuance number will likely draw the attention of traders as we move through the rest of this year, with each supply date a new catalyst on the calendar, on the off chance that the auctions do not go as well as planned.

Image 1: Shape of the Treasury futures yield curve today, two months ago and six months ago

On the other side of supply is demand. The Treasury report highlighted the possibility of reduced demand from foreign buys due to various factors. A primary factor is the increase in yields on foreign bonds, especially notable in Japan where the Bank of Japan recently adjusted its yield curve control from 50 bps to 100 bps. If we take into account FX hedging, Japanese Government Bonds (JGB) now appear more attractive to Japanese buyers relative to U.S. Treasuries. 

However, another source of demand has been U.S. retail, particularly high net-worth accounts, seeking higher yields on savings than being offered in bank accounts. Many have shifted funds from bank deposits to money market accounts, aiming to secure higher risk-free yields. When we look at the shape of the Treasury yield curve, which we can find in the CME Group Treasury Analytics tool, we see that while the level and the shape of the yield curve has changed over the last six months, the two-year part of the curve has consistently maintained higher yields. This may be the driving force behind why many traders seem to want to stay in the front part of the yield curve and not move out to “lock-in” the lower yields we see in the five- to 20-year portion of the curve. In turn, this means less liquidity in this portion of the curve, which forces Treasury to look in other places for issuance. 

Is there enough demand from U.S. retail to soak up the increased supply from U.S. Treasury? Continue to read and find out. 

Image 2: Quantitative tightening (QT) by the Federal Reserve is starting to pick up

Another source of pressure on the Treasury curve is the ongoing quantitative tightening (QT) being done by the FOMC. Right now, the balance sheet shrinking is a function of maturing bonds where proceeds are not being reinvested. This trend started in the summer of 2022, resulting in the balance sheet shrinking by around $500 billion by March 2023. However, with the banking crisis, the balance sheet grew again by about $300 billion. In recent months, we’ve resumed reducing the balance sheet and have reached $8.2 trillion once again. This pace is expected to ramp up in September to $95 billion per month, which will add to the pressure across the curve because market participants will likely need to step in to replace the demand from the Fed that will not be there. This all serves to weaken the market structure of the Treasury market.

Image 3: What will the increased Treasury issuance, coupled with steady quantitative tightening, mean for the shape of the yield curve?

This brings us to the question of the yield curve. Regardless of which period you prefer, whether it be 3-month vs. 10-year, 2-year vs. 10-year, or 5-year vs. 30-year, the yield curve has been inverted to historical levels. Many will tell you the yield curve is the single best predictor of the economy, since it has a 100% hit ratio, every time it has inverted, we have had a recession. The problem is, the lead time before the recession is variable, sometimes less than a year, other times two years in the future. This can make it difficult to use as a trading tool. 

Now it has been more than a year since the yield curve inverted and we are still near the most inverted levels since the 1980s. This may be seen largely as a function that the market is anticipating lower yields in the future due to rapidly falling inflation and the three forces of debt, demographics and disruption that will likely permanently impair potential growth. 

However, we now have a combination of Fed QT and increased Treasury issuance, which may be hitting the 10-year part of the curve. This brings in the risk of a bear steepening to the yield curve. While the yield curve itself has a variable lag until recession, we do know that once it has inverted, it is when the curve re-steepens over 0 bps that a recession is nearly imminent. You can see the recession colored in red versus the yield curve with a line drawn at 0 bps. Could this re-steepening be the signal that the Fed needs to cut rates?

Image 4: What will the economic data mean for an FOMC that may be paused but is data dependent?

Now let’s consider a FOMC that has unofficially paused, but says it is data dependent. Future hikes, or presumably cuts, are a function of the economic data. The chart above is the Citi economic data surprises. It is a mean-reverting series centered around zero. It is not measuring the absolute economic data, but where the data comes in relative to expectations. When it consistently disappoints, forecasters tend to lower expectations, and the data will then be better when it comes in. It is true in reverse, with better data met by a higher bar and therefore more disappointments. 

You can see the cyclicality of this data as I have drawn in red a very basic cycle. The data fits this rudimentary curve well.  I have also drawn horizontal lines at +/- 70 as the data rarely goes above or below these levels. 

You can see the current data surprise is +77 so it is coming in better than expected. This is largely driving the soft-landing narrative as positive surprises indicate that growth numbers are better and inflation numbers are lower. With the level perhaps not at an extreme like we saw in Covid-19, but at a level that would be the higher in a decade otherwise. Could we be in a period where the economic data will start to disappoint?  What does this mean for an increasingly data dependent Fed?

Image 5: Citi inflation surprise time series

Citi has another series of data that looks only at inflation surprises. This data also fits a cycle well and I can see that the better data, or lower inflation surprises, might be coming to an end here on a cyclical basis. Given the CPI and PPI are lapping lower numbers this fall, this may not be unexpected. Could lower economic surprises be driven by higher inflation surprises? Could this confuse traders who are trying to guess the next move by the FOMC?

Image 6: University of Michigan inflation expectations – 1-year and 5-year

The Fed under Bernanke often spoke about the anchoring of inflation expectations. I have mentioned this before where inflation (or deflation) is not a number but a mindset. When consumers start to think that inflation will be persistently higher, consumption behavior will change, but more importantly, wage expectations will also change. We may be seeing this as we are going through wage negotiations across a variety of industries, with unions asking for, and in most cases getting, much higher concessions than we have seen in many decades. 

The chart above may show some of this anchoring. Both series come from the University of Michigan. The white line is 1-year expectations, which are falling along with CPI. The blue line is 5-year inflation expectations, which you can see are much less volatile but have moved to a higher range from 2.5% pre-Covid-19 to 3% now. Are consumers starting to focus on a new permanently higher price regime? 

Image 7: University of Michigan inflation expectations compared to Oil and Gasoline futures

What is driving this focus on a higher price regime? In part it may be the higher cost of gasoline, itself impacted by the higher cost of oil. I have drawn onto the original chart of 1-year inflation expectations, the Gasoline futures in orange and Oil futures in purple. I can see there is a good fit with these series. You can ask any consumer about the price of various products. Nearly every consumer would likely know the cost of a gallon of gasoline due to frequent purchases and prominent advertising of its price. 

Will the recent rise in Oil and Gasoline futures lead to an upward shift in inflation expectations? What will the FOMC think about this? Will it be mentioned in Jackson Hole at the end of August or at the September FOMC meeting?

Image 8: Cross correlation of CME Group futures products

This correlation between oil and inflation, and inflation and interest rates, is not lost on traders. I can see from the cross-asset correlation tool that the CME Group provides that the correlation of implied volatility, or the expectation from the options market of the movement in futures going forward, varies across products. However, I’d like to highlight a figure on the chart: the correlation between Crude Oil options and 2-Year Note options is currently at 0.37.

Image 9: Historical time series of correlation between 2-Year Note options and Crude Oil options

If I click onto that cell in the table, I can see the time series of that data. I can see that the recent correlation of implied volatility between oil and 2-year notes of 0.37 is at the highest we have seen over the last year. A year ago, when we were still very worried about inflation, this correlation was close to zero. 

What do traders know or think they know going forward about the linkage of expected crude oil movement and expected volatility in 2-year notes?

Consider this correlation, I remember reading a recent BBC story about a Russian ship in the Black sea getting hit by a drone, likely sent by Ukraine. Ukraine has warned commercial vessels that entering the Black Sea might expose them to drone strikes. I believe this may negatively, if not permanently, impair the ability of cargo ships to get any insurance. Without this maritime insurance, products will not go in or out of the Black Sea. This means that Russian oil (and other products) that have been skirting embargoes, are now under another threat. 

Could a shortage in the supply of these products lead to increased oil and commodity prices, resulting higher inflation? Will this anchor consumer inflation expectations to even higher levels? What can or will the FOMC do about this?

Image 10: Commitment of Traders report of 2-Year futures

Perhaps for a variety of these factors, leveraged money are expecting lower TU prices going forward. I believe we see this because the net short in TU futures has been steadily growing all year long, even as the market has been expecting the Fed to pause. From the chart above, it’s evident this doesn’t seem to arise from spreading activity. Instead, it involves outright shorts in futures. Surprisingly, this is happening even though yields are approaching five percent, which seems disproportionate relative to the stance of Fed Funds futures. What do leveraged money accounts anticipate?

Image 11: Daily Ichimoku Cloud chart for generic TU first contract

Now, looking at the daily Ichimoku Cloud chart for the generic first contract of TU, I can see that price has been on a relatively steady decline for a year. There was the period back in March, which saw a strong flight to safety bid, and a move above the cloud area. However, this has quickly reset, and prices look to be moving lower again. I see a fair bit of resistance overhead in the futures now.

Image 12: CVOL levels for Treasury products

Above there are two charts from CME Group CVOL tool. The first shows the CVOL levels of all Treasury products. I can see that across the board, CVOL levels are at or near the lows of the past one year. This is especially true for 2-Year Note options. 

The bottom graph is the 2-Year CVOL zoomed in. I not only look at the CVOL level relative to the underlying, but also UpVar, DownVar, and Skew. As implied volatility has collapsed, we have seen UpVar and DownVar collapse as well, with traders likely looking to capture risk premia wherever they can find it. 

Skew has started to move a bit higher, favoring upside options. However, at these low levels, long options strategies start to look increasingly more attractive to me. The upside of long option strategies is that the buyer can profit on big moves in either direction. The downside is that these strategies are instant gratification, with the need for events to unfold sooner rather than later, lest theta, also known as time decay, erode a trader’s potential profits. 

Fortunately, as we have gone through in detail, I believe we have a number of catalysts occurring in the next month such as Fed meetings, Treasury issuance, geopolitical events, trader positioning, and economic data. It is difficult to know which may be a catalyst for potential movement. However, if I am buying options, I feel more comfortable when I know there are several possible events that can shake up the supply and demand balance in the futures market. 

Image 13: Comparison of TU implied vs. historical volatility for the past two years

If I look at both implied and historical (realized) volatility for the past two years, I see that implied vols in blue are at the one year lows but still not the lowest of the past two years. However, I can see historical volatility, which is even lower than implied, is below the two year average and well below the levels hit during the March banking crisis as well as the early 2022 geopolitical events in Europe. 

I can also see that while the average historical volatility the last two years is around 2.5%, when there are catalysts or events, it is not uncommon for volatility to spike to four percent, five percent, or even above eight percent. With many catalysts on the horizon, could one of these take us above the long-term average? Could it take us above where the implied volatility is pricing it?

Image 14: Expected return of a TUU3 long 101.75 straddle

Putting this together, I am inspired to get long convexity in TU options. 2-Year Treasury options have become increasingly popular at CME Group, with open interest already double what it was this time last year. 

I priced here a TUU3 101.75 straddle, which you can see costs 0.28 on a 2.43 implied volatility. The premise of this position is that implied volatility is historically cheap, positioning in the futures may be extended and there are a large number of potential catalysts on the horizon. 

In buying this straddle, I can take one of two approaches. First, I can simply look at it as a breakeven trade, thinking that I am not sure which way we may move, but believe the move is likely to take us below 101.09 or above 102.06 at expiration. This is the simplest way to look at this idea, but it is not my preferred way. The second way I can approach this is to suggest that the implied volatility priced into the options is too low relative to expected future realized volatility. If I believe that the current sub two percent realized volatility will move toward the long-run average of 2.5%, and perhaps spike even higher on a catalyst, I can profit by buying this straddle, and routinely delta-hedging the position at either pre-determined intervals (e.g., every 0.5 or one standard deviation) or at pre-determined times (i.e., midday and at the close). This then becomes a position that is not predicated on a directional move in either direction, but a position predicated on a return from below average historical volatility to average if not above average historical volatility based on the variety and abundance of potential catalysts. 

The trade is not without risks. As I mentioned, being long options is an instant gratification idea. As you can see from the expected return graph, every day it takes to get movement, the position accrues more time decay, which means the breakeven levels get wider and wider until they approach the 101.09 and 102.06 that the breakeven trader would see. The sooner a move happens, the more quickly a trader can profit. The longer it takes, the harder it becomes. 

Given the lack of movement in the front-end of the Treasury curve over the last few months, it may be difficult to anticipate that this idea can make sense. After all, even at these one year low levels, implied volatility is higher than the actual historical volatility happening in the market. However, volatility is like the weather. Tomorrow’s weather may be similar to today, but eventually this weather may return to longer term averages. This can particularly be the case when there are potential storms (catalysts) on the radar. We do not have to predict the exact level it goes to, but when there is an attractive reward to risk entry level for long implied volatility positions, traders can possibly benefit from stepping in when no one else wants to. 

Good luck trading!

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