Options Trading: Don’t Worry About 3% Bond Yields

Posted On May 8, 2018 12:43 pm

Lately we’ve been discussing whether the flattening yield curve is indicative a coming recession or if yield on the 10-Year crossing above 3% would choke off growth and tip a sell-off in stocks. A recent article in Bloomberg suggests that neither should be a cause for concern, pointing to current patterns in options trading as evidence that market participants are not greatly worried about a sudden surge in interest rates.

When the yield on 10-year U.S. Treasury notes reached 3 percent on April 24 for the first time in more than four years, investors began to wonder whether it represented a tipping point that would cause borrowing cost to surge even higher at an accelerating pace. Options prices, which contain valuable information about the market’s assessment of near-term upside potential and downside risk for a wide range of assets, show few indications that rates will suddenly shoot higher, for two primary reasons.

First, for the rate at which bonds are selling off to accelerate sharply, there would have to be a large and sudden exodus from Treasuries into another, more attractive substitute asset. But across the developed world sovereign debt yields are much lower, at less than -1 percent on German and British 10-year bonds and below -0.5 percent for Japanese government bonds, versus a real yield on the benchmark Treasury of 0.8 percent.

While momentum traders will certainly short Treasuries, the impact is not likely to be substantial. Overseas governments, federal agencies, the Federal Reserve, mutual funds, pensions, insurance companies and endowments collectively control about 93 percent of the U.S.’s $21 trillion of national debt. These are not wholesale sellers and, realistically, they have nowhere else to park their money.

Consistent with this, option prices show a preference for Treasuries. For example, the implied volatility on 10 delta three-month puts is nearly one volatility point higher than accompanying calls for 10-year German and Japanese government bonds, but only 0.2 volatility point higher for Treasuries. The option market is therefore saying there is more risk to the downside for German and Japanese bonds compared with their U.S. counterparts. With no attractive substitutes available, wholesales shifts away from U.S. debt are unlikely.

 Related: Learn Why Sector Rotation is Good for Your Portfolio

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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