(Bloomberg) -- German bunds are the most stable since just before the sharp selloff in April 2015. Looking through the options lens, the market is skewed for higher yields.
The recent tight trading range for bunds highlights a sense of balance in the market. Short-dated implied volatility is back to levels not seen since prior to the government bond tantrum three years ago. Back then, Bill Gross called German 10-year debt “the short of a lifetime,” and this year he has forecast a mild bond bear market. While bund futures options and swaptions are skewed toward higher rates, they don’t suggest a similar slump.
European Central Bank gradualism, contained policy uncertainty and low macro variance is putting a lid on current volatility. The 2015 spike in volatility came amid extreme bund valuations and low market liquidity, after German yields hit an extraordinarily low point. That was an example of a release of the artificial suppression of the energy in bunds. The containment of risk depends highly on the credibility of monetary policy.
Ten-year bunds are more likely to carve out a higher yield range, with low realized inflation containing the long-end. German yields negative out to five years have much more room to price the medium-term trend of rate normalization and an eventual exit from emergency interest rates.
- Decreasing U.S. duration and going into the front-end vs fading the negative yields in the belly of the German curve may appeal to some investors
- Payer ladders (which are short volatility and skew) may be effective for those who see higher yields, but capped, and want to remain protected in a rally
- Long-gamma positions continue to suffer negative carry given lower realized volatility; suggests long-volatility ideas need to be structured to neutralize gamma exposure (forward vols / calendar spreads using mid-curve options have short gamma exposure and positive theta benefit)
- Supportive factors that have turned January bund selloff around include local EGB supply peak which sees supportive flow backdrop in April, price-insensitive end-user demand, increased USD funding costs leaves EGBs more attractive than USTs for currency-hedged Japanese investors (who may buy on back up in yields, helping to limit the momentum in a selloff), anchored Treasury long end, contained term premiums and signs of cooling global growth (but still robust)
- Ignore equity convexity at your peril, whereas Draghi and low inflation risk premia keep bund convexity options at bay
- 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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