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

Posted On May 8, 2018 12:43 pm

Indeed, rising yields may attract overseas money, constraining the pace of any selloff. On April 26, Bloomberg reported that several Japanese insurance companies – risk averse and cautious by nature — are opting to buy more Treasuries without a currency hedge because the yield differential between U.S. and Japanese government bonds is now so wide that the extra cost for protection isn’t merited.

The second reason yields could jump quickly would be if there was a sudden inflationary shock. Inflation erodes the value of a bond’s fixed coupon and principal payments, leading investors to demand higher yields.

However, aside from a commodity disruption, there are few signs of a significant increase in inflationary pressures. That’s largely because the Federal Reserve began tightening monetary policy well before signs of faster inflation appeared. In addition, technology has brought down barriers and heightened competition in every sector, reducing pricing power and likely keeping a lid on prices.

Although options trading doesn’t point to U.S. yields rising at an accelerating pace, yields are likely to continue to climb as the Fed continues to normalize monetary policy. Years of ultra-loose policy has left real rates – or interest rates less inflation – artificially low.

Yields on 10-year Treasury Inflation-Protected Securities are around 0.8 percent, suggesting that the bond market sees an average rate of real gross domestic product growth in the U.S. over the next decade of about 0.8 percent. Most economists would argue that normalized real GDP should be around 1.5 percent to 2.0 percent. So, real rates still have the potential to rise by at least another 0.7 percentage point, implying a fair value for the benchmark 10-year Treasury of about 3.7 percent.

So while the trajectory of 10-year Treasury yields remains up as real rates rise, 3 percent isn’t a tipping point based on options market prices, and any selloff should be controlled in the absence of outflows to other developed-market sovereign debt assets and/or sharply higher inflation.

It’s not about the ultimate level of yields, but the path they take. A violent surge in real yields would likely not be welcomed by the market, while a controlled and gradual rise in the real cost of capital can certainly be absorbed.

 Related: Here’s How to Beat the May Market Blues

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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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