Since the September 2024 FOMC meeting, something rather unusual in rates markets has been occurring. While the Federal Reserve is cutting short-term interest rates, long-term interest rates have been rising. In fact, there is only one other time in the 50 years of Federal Reserve interest rate policy where one can see this happening, which was the mid-90s when the FOMC cut rates because of weakness in global economies even though the U.S. was experiencing a soft landing. Some will suggest this is the work of the “bond vigilantes,” which is the name given to the bond market participants that presumably force policy discipline. In trying to understand what those participants may be thinking, one can attempt to decompose the movement in the yields. In the top chart, one can see a 100 basis point move from 3.6% to 4.6% from mid-September 2024 to the end of December 2024. On this chart, there are two other measures. The first in orange is the 5-year forward inflation swap level. It has similarly risen from 2.35% to 2.50% as market participants see the possibility of higher inflation over the next several years, well above the FOMC 2% target. However, the bigger move has come from the term premium, that amount bond market investors want to be compensated for moving further out the curve. In the years of quantitative easing, this amount has been suppressed and even ran negative for a time. Though, since September 2024, the term premium out to 10 years has risen from -42 basis points to +43 basis points, a rise of 85 basis points. Thus, I’m able to see that the entire 100 basis point rise of the yield is split between these two measures, with the lion's share being the rise in term premium. In pre-QE periods, this measure has averaged closer to 1.5-2.0%, thus there is as much or more scope for it to continue to rise than to compress again.

The bottom chart is a daily Ichimoku Cloud chart with a couple of different trend lines drawn. This chart is important because it shows yields have broken above all levels of resistance and are now targeting the highs last seen at 5% in fall 2023. The new year looks set to have a very interesting beginning to it given the potential for a bear market in bonds. As a reminder, the 10-year U.S. Treasury yield is the rate upon which all other asset markets are priced, such as  sovereign bonds via a spread, corporate bonds via a spread, mortgages, equity valuations and futures price curves.

Bond market traders know the yield and price move in opposite directions, so now I’ll turn to the futures market to see what impact on 10-Year Treasury Bond futures this breakout in yields has had. The top chart shows the daily Ichimoku chart. This shows a breakdown through support in October 2024. The price came up and tested the cloud level in early December 2024, but failed very quickly. Now the cloud, that level at which buyers and sellers have been transacting, is heading lower suggesting the bears are in control and price looks set to trend lower.

The bottom chart steps back and looks at price on a weekly basis. This shows that, over the summer 2024, prices tried to break out above the cloud. This breakout not only failed, but now the price as well as the lagging span have both fallen beneath the cloud, suggesting the bears have fended off the bullish advance and are now reestablishing control on a weekly basis. The cloud has yet to turn lower, so it's still a battle between bulls and bears on a longer-term chart, but as of now, the bears are slightly in the lead. Futures prices are in a precarious position.

Layering onto this poor technical behavior is the idea that there is a load of supply set to hit the market in 2025. Prices and yields attempted to rally in November 2024 to early December 2024 when President Trump named Scott Bissent as the Treasury Secretary. As a market veteran and a person many bond market investors have respect for, there was a sense that the $7 trillion of supply set to come from the Treasury could be handled in a manner that wouldn't upset bond markets. However, perhaps because of tariff threats or concerns about the time it could take to get appointments through, those concerns have begun to materialize again, which is what the term premium markets are telling me.

The Treasury Auction Tool from CME Group allows a trader to see how the markets behaved around the auctions for paper of different maturities throughout 2024. One can see the times when there were large auction amounts, particularly five- and 10-year paper, the bid-to-cover ratio struggled. Perhaps the bond vigilantes sense the flood of issuance set to come in 2025 will create some concern that the market would be able to handle these amounts, since there were struggles in the past on lesser amounts of issuance.

This backdrop sets the tone for the possibility of increased volatility in the coming year. In the chart above, the three lines are the 10-Year futures price (dashed), CVOL Index (blue) and skew ratio (red). A pattern developed over the course of the year: as futures prices fell, the CVOL Index rose and the skew ratio fell. This suggests not only a demand for options insurance as futures fell, but particularly a demand for downside options. While the CVOL Index has moved higher, it's still well below the highs seen before the election. The same is true for the skew ratio, which bottomed around the election and moved higher, suggesting hedges were unwound post the U.S. election.

The next chart compares the implied volatility to historic (realized) volatility, overlaid with futures prices. When futures prices fall, as markets saw in spring of 2024, both implied and historic volatility rose. In the September 2024 to the November 2024 period, one can see implied volatility rising with futures falling, even though historic volatility stayed the same, creating an increase in risk premium. This risk premium collapsed after the U.S. election as implied volatility moved to the level of historic volatility. Now, as futures are falling, there's a small rise in implied volatility even with historic volatility reducing into the end of 2024. Does this suggest the potential for more of a spring-like move where both volatilities increase post-holidays? Or does it suggest the risk premium rises? Either way, it looks like a falling futures price should see a rising implied volatility.

The next step for me is to look at the shape of the term structure of options. While the skew gives the trader a measure of puts versus calls, CVOL gives me a measure of current volatility versus its own history‌ and the implied less historic tells me about risk premium. The term structure gives the trader a measure of what expirations are thought to embed the most impactful events when it comes to volatility. The trader can see that January 2025 volatility is compressed, most likely due to the large number of holidays over the course of the time period. Implied volatility starts to normalize and actually hits a near-term peak at the March 2025 expiration. This is after the inauguration, after the time the important nominations should be approved‌ and in time for the first of the large Treasury auctions to happen. The market suggests and ever-increasing implied volatility in the first quarter of 2025, then staying at this elevated level throughout the summer. 

Putting these views together, a trade begins to materialize. The breakout in yields combined with the breakdown in futures prices, both daily and weekly, indicate a market dominated by bears. Futures prices are likely to face pressure in the early part of 2025. This should not be surprising given the risk of a delay in the appointment process and the large auctions that are set to begin. In 2024, when futures prices fell, there was a rise in implied volatility, whether that was met with a rising historic volatility or not. While CVOL levels have gone up, they are below the highs traders have seen even recently. Thus, there is a bearish directional call and a reason to lean net long options. Typically, one uses butterflies when there is a very nuanced view of where futures can end up. However, if one uses a split-strike butterfly, which is not symmetric and has a lower wing that is closer to the guts of the butterfly, this can change the view embedded. I have chosen a 107.5-105.5-104 butterfly for March expiration, which is right now the highest part of the curve. I am net long options in this spread and benefit from a fall in future prices. If prices move too far and go below my lower strike, while this would lead to a loss in a symmetric butterfly, I am still able to lock in some gains. Yes, the maximum gain occurs if futures are near 105.5 at expiration, but anywhere below the breakeven of 107.05 a trader would make money. Only above would the trader lose the premium invested, therefore, it is a defined risk trade. While the set up suggests being long some options, the skew pricing in a premium for downside makes this more difficult, therefore, the desire for a put butterfly. The net result is a bearish trade, net long some options at a time of potentially rising implied volatility and low risk premium and taking advantage of the increased demand for downside options. I also ensure that if the market really breaks down with the potential negative catalysts in Q1 2025, I will make money on a negative move that's larger than I anticipate at this time.

Good luck trading!

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