Any ideas on how to set up a trade for greater volatility.
Reuters
U.S. rate market exudes eery calm on economy, Fed
Thursday July 15, 12:10 pm ET
By Eric Burroughs
NEW YORK, July 15 (Reuters) - The U.S. interest-rate market is exuding nothing but calm on the near- and longer-term horizon even although the Fed is raising official rates and the economic outlook is shrouded in uncertainty.
The volatility market, which gauges expectations for shifts in U.S. Treasury yields and the yield curve, has seen prices slide to the lowest levels in three years and in some cases the lowest since 1998, the nightmare year of the Russian debt default and Long Term Capital Management hedge fund meltdown.
Given the amount of doubt not only on the economy and pace of Fed tightening, but a pending U.S. presidential election and the threat of terrorism, strategists believe the relentless decline in actual and expected interest-rate volatility has perhaps gone too far.
Much of the decline reflects the widely-held view in the markets that the Fed will, as promised, lift rates at a steady pace, and so far nothing has shaken that view.
Sadakichi Robbins, head of fixed-income trading at Bank Julius Baer in New York, said the shape of the Treasury yield curve and volatility are critical and that "so far, they haven't worked together to cause any voodoo."
"At some point I suspect they will, I just don't know when," Robbins said.
Even for imminent events, including important inflation news Friday and congressional testimony from Fed Chairman Alan Greenspan next week, the outlook is for next to no volatility in Treasury yields.
NO STOCK SHOCK EITHER
This extraordinary calm prevails not just in the interest-rate arena:
The VIX volatility index (CBOE:^VIX - News), a measure of investor fear in the S&P 500 (CBOE:^SPX - News) stock index, has subsided to near its lowest levels since December 1995 -- the easy-going, Goldilocks days of the 1990s expansion and stock market boom.
"It is unusual heading into a Fed (rate tightening) cycle that volatility is so low. The beginning and end of Fed cycles historically are volatile episodes," said Vaidyanathan Venkateswaran, a strategist at Lehman Brothers in New York.
"The market is essentially recognizing it has a lot priced in and the Fed is not signaling anything different. But the question is the pace to get there, and the market is underestimating potential volatility on a forward basis."
Currently Eurodollar futures (0#ED:) are pricing in a 2 percent federal funds rate by year end, up from the current 1.25 percent, and a roughly 3.50 percent rate by the end of 2005. The Fed has said it plans to keep lifting interest rates at a "measured" pace unless inflation picks up markedly.
The key question for volatility is market expectations of where rates are going compared to forward rates. Forward rates are derived from current yields and the yield curve, and are used to price most interest-rate derivatives.
When comments from Fed officials or surprising economic news challenges expectations for where rates are heading, the whole interest-rate market usually reacts quickly and harshly, from Treasury yields to Eurodollar futures to volatility.
The volatility market includes exchange-traded options on Treasury futures and options on an interest-rate swap, known as swaptions. It is also made up of other derivatives like straddles, strangles, caps and floors. Volatility and expected, or implied, volatility are used to price these derivatives.
There have been plenty of surprises this year. Earlier in the year jobs growth suddenly beat all expectations earlier, only to slow sharply in June. Inflation fears have hit a fever pitch and then died down. But even as yields and futures reacted wildly for a day or two, the outlook never wavered.
"The market is expecting the forwards to be realized and for everything to go according to game plan," said George Oomman, U.S. interest-rate derivatives strategist at Credit Suisse First Boston in New York.
As Robbins at Bank Julius Baer put it, the range-bound Treasuries market reflects the fact that the early stages of the Fed credit tightening cycle have been well anticipated but "we're just not in the heart of it yet."
Some argue the market is right to expect diminished volatility. One reason is the sharply reduced hedging needs of mortgage portfolios, which have driven much of the severe market moves of the past few years.
Eric Hiller, chief interest-rate strategist at Banc of America Securities (News - Websites) in Chicago, has written about the particularly sharp decline in intermediate volatility under reports titled "Hakuna Matata," the song from the stage musical and cartoon "The Lion King," whose theme is "no worries." |
