Goldman, Morgan Stanley Back Bets on Lower Bond Volatility

Goldman Sachs Group Inc. and Morgan Stanley are telling clients to sell short-term Treasury volatility as weaker-than-expected U.S economic data has kept the yield curve in a tight range.

Measures of volatility in global bonds cratered after Friday's weaker-than-anticipated U.S. payroll report, with Wall Street strategists now lining up to go short volatility over the summer.

Three-month 10-year swaption volatility — a measure of how much yields are implied to move — slid by the most in 10 weeks, pushing it down to levels last seen in mid-February before the chaotic global selloff later that month.

"With no clear catalyst in sight, a period of continued yield consolidation will mean further downward pressure on delivered vol," Goldman Sachs strategists led by Praveen Korapaty in New York wrote in a note Friday.

Investors should sell three-month straddles on 30-year yields to capture the move, the strategists said, referring to a bet that yields will be unable to break out of their current range. That should help offset any loss on existing long-volatility positions, they wrote.

While flows were broadly limited in Monday's early U.S. session, the recent stand-out theme of short volatility structures via 10-year strangle sales reemerged, including one bet for a premium of $3.75 million.

Mixed jobs data has clouded the economic outlook and looks set to deter the Federal Reserve from announcing the start of tapering, with bond yields consolidating as a result. Selling volatility as a way to generate enhanced yields was already gaining in popularity before the payrolls data.

One favorite expression among traders has been to sell so-called strangles — a structure made up of out-of-the-money call and put options — expiring in either August or September.

A measure of three-month volatility in the U.S. currently implies a break-even range of around 28 basis points for 10-year swaps and Treasuries, suggesting benchmark 10-year yields may move between 1.85% and 1.29%, versus about 1.57% on Monday.

Short-Term Jitters

Nevertheless, some turbulence could be triggered by Thursday's U.S. inflation data. Analysts at Bank of America, Commerzbank AG and UBS Group AG predict readings of 0.5% or above for core month-on-month CPI, higher than the consensus forecast of 0.4%.

"The main risk is a pick-up in volatility that would shake carry traders out," said ING strategist Antoine Bouvet, predicting that the reading might be much higher or lower than expected given questions about the pace of the economic recovery.

He recommends suspending carry trades in the five-to-seven-year part of the Treasury curve, which is more sensitive to changes in monetary policy.

UBS, meanwhile, sees the print coming in as high as 0.7%, which could send 10-year Treasury yields toward year-to-date highs, said John Wraith, head of U.K. and European rates strategy.

"Given recent nervousness about, and focus on, possible inflationary problems coming out of the pandemic, that would likely trigger a jump," Wraith said.

Morgan's View

Others remain unconvinced, not least as traders are well aware of near-term pressure on inflation. Morgan Stanley agrees that volatility will stay subdued in coming months, before picking up from August onward.

"Our base case is for vol to trade flat to somewhat lower in the near term, which is also supported by our quantitative fair value models for implied volatility," strategists David Harris and Kelcie Gerson in New York wrote in a note last week. "However, we do think that the FOMC meeting at the end of July is a risk event, as there may be early discussions of tapering."

They recommend using a so-called calendar spread, selling two-month expiry volatility on 10-year rates versus buying five-month expiry to capture the subdued near-term outlook and rising volatility in the three months to early November.