(Bloomberg News) Treasury volatility over the shorter term may increase as the Federal Reserve begins its second round of asset purchases under quantitative easing, according to Morgan Stanley's James Caron.
Bank of America Merrill Lynch's MOVE index, measuring price swings based on over-the-counter options maturing in two to 30 years, climbed yesterday to 91.60, the highest level since November 2, the day before the central bank announced that it will buy $600 billion in additional government debt through.
"Many expected that volatility would have declined since QE is a prescription for low and stable rates," Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York, wrote in a research note. "We should get used to the fact that rates may swing around a lot but ultimately stay in a range unless fundamental conditions change and warrant a break in that range. Perhaps this is the new world order that QE will usher in."
Investors should buy variance swaps on Treasuries to bet that volatility will increase within a narrow range as positive economic reports cause Treasuries to fall and negative figures give the market a boost. Variance swaps are over-the-counter products whose profitability is based on the volatility experienced by a security over a set period of time.
The bet "can pay off even if rates stay in a range but vary a lot within that range," wrote Caron, whose firm is one of the 18 primary dealers that trade directly with the Fed.
The Fed will purchase $105 billion of Treasuries over the next month under an expansion of monetary stimulus measures to reduce unemployment from a 26-year high and avert deflation.Treasury Yields
The benchmark ten-year note yield dropped three basis points, or 0.03 percentage point, to 2.63% yesterday after rising as much as 12 basis points. The yield on the 30-year bond fell two basis points to 4.23% after increasing as much as eight basis points to 4.33%, the highest level since May 18. The bond market is closed today in observance of Veterans Day.
Recent volatility in rates "may seem counterintuitive, but from a market trading perspective it's not," Caron wrote. "The important distinction to make is between time frames: short-term versus long-term."