(Bloomberg) -- For all the talk of a bond-market collapse, U.S. interest-rate options suggest no such thing.
More likely, long-dated securities are facing a gradual upward repricing in yields with the Federal Reserve determined to raise rates and U.S. tax reform potentially leading to larger deficits. Throw into the mix stronger U.S. economic growth and inflation that is picking up modestly, and you have the perfect recipe for low total returns from debt.
Several explanations have been offered for the bond selloff -- a policy shift at the Bank of Japan, increased government debt supply globally and a report suggesting China could look at slowing purchases of Treasuries that has since been pushed back on. But it may well be that a more fundamental factor is at play: the paring of the deep economic pessimism in long-end rates, given mounting expectations for U.S. growth to be sustained by tax reform and Fed policy.
The short-dated volatility skew between payer and receiver options on 10-year dollar swap rates is flat, indicating limited expectations for significant moves in long-dated yields. A steeper skew would indicate payers gaining relative to receivers, signaling expectations for higher rates. Short-dated skews tend to predict changes in underlying rates.
Bond-market pundits and social media have stirred the public’s imagination by alluding to a breach of technical levels. U.S. 10-year yields have now climbed to 2.56 percent, above the secular bull trend line that comes in at 2.47 percent this month, after having failed to convincingly end a month above that for nearly three decades. The next higher trend line, which has only been touched twice, is currently at 2.68 percent.
In any case, both trend lines have been falling at about 20 basis points a year, suggesting they will inevitably be broken at some point unless the chimera of negative rates becomes a reality.
- Contained upward moves in yields bode well for ATM payers vs strangles, with the selloff being a non-volatility event. Central bank policy remains the single-most important factor driving volatility in rates through the impact it has on the psychology of risk-taking and supply of assets
- Distortions created by monetary policy and build-up of leverage limit the extent to which long-term yields can rise, given the increased sensitivity of the economy to rates compared to previous cycles
- An important explanatory factor for the increase in long-end yields is U.S. breakeven inflation, with the 10-year measure rising to nearly the highest level since 2014, driven by higher oil prices, dollar weakness and tax reform
- TIPS outperformed most buckets of the Treasury market in 2017 and will be a useful part of an allocation strategy to protect a portfolio from inflation given tightening labor markets and tax reform
- However, the increase in oil costs may bring more fracking online and cap price increases while the Phillips curve ignores the level of debt, demographics and technology
- Longer-term structural backdrop will have to change for significantly higher yields
- 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
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