Repression, Compression, Expression

Investors should consider adding short volatility as a source of carry.

When the European Central Bank announced its plan for quantitative easing (QE) on 22 January 2015, it joined the ranks of central banks, including the Federal Reserve, the Bank of England and the Bank of Japan, that have embarked on unprecedented sovereign bond purchase programs in the hopes of stimulating their economies and fighting off deflation. This has driven yields down to historically low levels. Some regimes, such as the ECB and the Swiss National Bank, have gone further by instituting negative short-term interest rates. With the Fed acknowledging “international” developments in their last Federal Open Market Committee (FOMC) statement, financial repression is now a truly global phenomenon.

Yields are compressed and highly correlated, and volatility has risen
With 10-year German Bunds and 10-year Japanese government bonds yielding below 0.50%, 10-year U.S. Treasuries look attractive, even at 1.95%, to foreign investors (see Figure 1). And as the dollar index has strengthened, in no small part due to these new QE programs and other currency intervention, foreign capital has flowed into U.S. Treasuries and other U.S. asset markets. Thus, the cumulative financial repression has led to compressed and recently highly correlated yields in most developed countries, while markets have been volatile as investors react and adjust to the new environment. However, these recent short-term spikes in realized and/or implied volatility belie likely damped volatility at these low rates over time, suggesting a potentially attractive opportunity to sell longer-term volatility at current premiums.

Through this recent bout of market turbulence, implied interest rate volatility has remained well bid as investors look to hedge risks by buying options (insurance) against both a further decline in rates and a sharp reversal higher in the rates market. This is an interesting development from a historical perspective: Throughout the recent financial repression era starting with the second round of U.S. QE at the end of 2010, volatility has declined along with declining yields as we approach what was thought to be a “zero-bound” in interest rates. But with negative interest rates in France, Japan and Germany (see Figure 2), many have questioned if a zero boundary still exists in the US.

Amid this potentially deflationary environment, the negative interest rate tail in the US is more likely, but with US unemployment at 5.7% and GDP of 2.6% and 5% the last two quarters, we think any market perception that there is a chance the Fed will ease financial conditions is off base. In fact, we expect the Fed to begin to raise rates this year.

Selling options versus buying U.S. duration
For investors looking to add yield to portfolios, the low level and recent high correlation of global government bond yields, combined with the relatively high level of U.S. implied rate volatility, potentially make selling options more attractive than being outright long U.S. duration. Selling options may also offer a significant carry offset against a backup in rates in the U.S. market. This is particularly attractive for investors who believe that the U.S. economy will continue to outperform its global counterparts, since any increases in U.S. yields will likely be limited by the overall low global rate environment. While implied volatility levels are far from past highs, they do exhibit a larger premium relative to current rate levels than they have in the past (see Figure 3). It’s clear that given the recent linkage of global government bond markets, the level of U.S. rate volatility is quite high.

Now let’s look at the potential outcomes for selling 2y10y swaption straddles in the U.S.. While we could evaluate many different options, we focused on two-year straddle options on the U.S. 10-year swap rate, which currently trade at 858 basis points (bps). At expiration, this combination implies a terminal breakeven of 96 bps around the strike, currently 2.46%, or a breakeven range of 1.50% to 3.42% on 10-year swap rates. While the forward two-year/10-year rate has traded above our 3.42% breakeven several times in the past five years, the spot 10-year rate has been well contained within the breakeven band on both the high and low side since 2011 (see Figure 4). Simply put, as long as we are above 1.98% on the 10-year swap rate at expiration, the straddle sale will outperform the duration long in the same underlying forward rates. Furthermore, the straddle sale will outperform the U.S. duration long in all the scenarios above 1.98% on the 10-year rates at maturity.

Investors should consider adding short volatility as a source of carry
Historically, investors have looked at shorter-dated option sales as a preferred carry strategy. While we still believe short-dated option sales may be tactically favorable, ongoing global adjustments and policy moves may create ongoing short-term volatility in the near term, and longer-dated options sales are likely to outperform long duration strategically until the period of financial repression, global deflation concerns and yield compression has ended.

Since a return to 2012 yield levels in the U.S. will eventually result in lower volatility, now may be the time for investors to consider adding short volatility to their portfolios as a source of carry rather than being simply long duration. This may also help hedge against any potential selloff if economic data improves in the eurozone and inflation expectations rise due to QE.

The Author

Rick Chan

Portfolio Manager, Global Macro Hedge Fund Strategies

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