Volatility in the bond market is about to stage a comeback.
At least that’s what one trader is betting, judging by options-market activity signaling a conviction that Treasuries will either win big or fall hard in the next two weeks. The success of the wager, which involves an unusually large amount of money for an options strategy of this kind, isn’t tied to the direction of yields. Rather, it depends on the return of the kind of turbulence that hasn’t been seen in months.
On Tuesday, someone ponied up almost $10 million to buy out-of-the-money put and call options simultaneously on 10-year Treasury futures, in what’s known as a strangle, according to data compiled by Bloomberg and observations of trading levels. The position caught the market’s attention because it involved block sizes of about 63,500, according to CME Group Inc. data. A strangle of that magnitude is rare, and possibly unprecedented, say rates traders familiar with the market.
The strategy, which expires July 21, looked promising Wednesday, when Fed Chair Janet Yellen’s testimony sent the 10-year yield down as much as six basis points. But the decline came to a halt after the Bank of Canada hiked rates as expected.
Turbulence Needed
Therein lies the challenge for this trade: Small swings won’t cut it. Just to recoup the premium, the 10-year yield would have to rise or fall about 10 basis points from about 2.38 percent, according to data compiled by Bloomberg. Once it passes that point, there’s no cap to the potential profit. For example, it stands to gain about $50 million on a quarter-point move in either direction from the starting level, which would involve approaching this year’s highs and lows for 10-year yields.
The calendar over the next several days presents ample opportunities to rekindle volatility. In the U.S., political drama aside, the Labor Department releases consumer price index data Friday, which could influence the Fed’s timing for rate hikes and balance-sheet reduction. Retail sales data come out the same day. And, the day before the position expires, the European Central Bank announces a policy decision.
Counter-Trend
An increase in volatility would be a departure from the trend of suppressed price swings this year. The 10-year yield has risen or dropped by more than 10 basis points just four times this year on a weekly basis, compared with 10 times in the same period of 2016.
A measure of Treasuries volatility fell last month to levels that preceded the 2013 taper tantrum. The Merrill Lynch Option Volatility Estimate, or MOVE Index, derived from over-the-counter options on Treasuries maturing in two to 30 years, remains close to those lows.