Description

Summary

USD interest rate volatility is at generational lows, and USD rate options are the cheapest they’ve possibly ever been.  

The Merrill Lynch Option Volatility Estimate Index (the “MOVE Index”) is a blended measure of implied normalized volatility for one-month USD interest rate options across the yield curve; (In other words, the MOVE Index is roughly to bonds as the VIX is to equities.)  This is maybe the single best metric to which I can point you to say that rate vol is cheap relative to the prior 2006/2007 and 1998 troughs.  

MOVE <INDEX> <GO> GP <GO>

There are two ideas that I think are interesting: (1) buying CMS Rate Caps and (2) buying CMS Curve Caps.

CMS Rate Caps

Back in 2009, Julian Robertson highlighted an “insurance policy” he owned in case of “unbelievably high inflation.”  By buying CMS Rate Caps, Robertson owned “the equivalent of buying puts on long-term [bonds].” Thanks to the internet, we can review some timestamped pricing for comparative purposes.  

Tiger owned five-year ‘rate caps’ on long-term rates; buying caps is the equivalent of betting on higher rates (or lower bond prices).  

http://www.valueinvestorinsight.com/pdfs/May2009VIITrial.PDF  

https://www.marketfolly.com/2009/10/replicating-julian-robertsons-constant.html  

The reason why these options on long-term rates are cheaper today is that the key determinant for pricing these caps—implied volatility—is ~40% lower today than it was for Tiger back in 2009.

5y Implied Vol on 10y Rates

USSN0510 <CURNCY> <GO> GP <GO>

5y Implied Vol on 30y Rates

USSN0530 <CURNCY> <GO>

To a simple value investor, it seems odd that options on higher rates are cheaper now—when the absolute level of rates is ~15-25% lower than back in 2009—but this is the world we live in.  

10y Rates versus 5y Implied Vol on 10y Rates

USSW10 <CURNCY> <GO> (left) versus USSN0510 <CURNCY> <GO> (right)

30y Rates versus 5y Implied Vol on 30y Rates

USSW30 <CURNCY> <GO> (left) versus USSN0530 <CURNCY> <GO> (right)

CMS Curve Caps

Interest rate curve options depend on the spread differential between two points on the rate curve.  These are a form of ‘curve steepeners’ with linear payoffs.

http://archive.fortune.com/2008/01/28/news/newsmakers/okeefe_tiger.fortune/index.htm

Appropriately enough, the biggest bet that Robertson has in his own portfolio at the moment came, he says, from a former Tiger who he had given some ideas on subprime shorts. Robertson has shared the strategy with the seed funds and some of them have followed him into it - with great success so far. Here's the idea: In the fall, Robertson invested in a derivative called a "curve steepener" that allows him to be long the price of two-year Treasury and short the price of the ten-year Treasury - betting that the difference, or curve, in the yield between the two will increase.

The investment reflects a negative outlook on the prospects for the U.S. economy that has been building in Robertson for years. He believes that the Federal Reserve will continue to flood the economy with money, weakening the currency and ultimately causing the Japanese and Chinese central banks to stop purchasing Treasuries, which will drive the price of 10-year bonds down. It's a macroeconomic hedging strategy that has already paid off handsomely.

So far in 2008, the difference in the between the two bonds has already increased from 97 to 138 basis points. "I've made a big bet on it," he says. "I really think I'm going to make 20 or 30 times on my money." Considering the momentum he has, it wouldn't be a surprise.

I don’t want to get caught up in a mental exercise of where the underlying spread differentials could go, but I would just point out that the spread between the 10y and 2y rates (“2s10s”) is at ~4-7bps (at ~2-5 years forward)—which is materially lower than the ~100-140bps when Tiger was publicly discussing the trade; the spread between the 30y and 2y rates (“2s30s”) is roughly flat (at ~2-5 years forward).  I am not saying that the spreads cannot go negative (it’s always darkest before it gets darker), but if you have any belief in the time value of money from ~2021 to ~2048, then you should buy curve caps.

Separate from the spread differentials being close to prior lows, the real attraction of curve caps today is that ‘curve vol’ is even more depressed than ‘rate vol’ (the one at generational lows).  As with rate caps, the pricing of curve caps is similarly affected by low implied volatility. Unlike rate caps though, curve cap pricing also benefits from the QE/ZIRP environment.

‘Curve vol’ (or ‘spread vol’) or the implied volatility for interest curve options is also affected by the correlation between the two rate volatilities.  The net result is that ‘curve vol’ effectively represents the volatility of the spread between the two rates.

The simple rule of thumb to keep in mind is that curve vol will rise if either the volatility of rate A or the volatility of rate B rises or the correlation of the two declines.  The chart below illustrates the impact on ‘curve vol’ (specifically, a one-year option on the spread between the 30y and 5y rates) when you flex the correlation input (50% / 70% / 90%).  

If you think about it, correlations compresses to almost ~1.00 when rate vol (throughout the curve) moves through an inflection point (e.g., flattening curve).  This is exactly what is happening today, with correlations currently close to ~1 pushing curve vol to the lows. Data for curve vol is difficult to gather because of the correlation input, but the following chart shows the impact over the last five years.

The chart below (indexed to 100) shows how 3y curve vol on 2s10s has decreased more than each of 3y rate vol on the 2y rate or the 3y rate vol on the 10y rate.  

Conclusion

There’s really no point in talking upside/downsides here, because it all depends on underlying rate, option expiry, and strike you like.  Realistically, you can construct baskets across those parameters that make ~10x on reversion to (non-peak) historical levels.

Important Disclaimer:  This report does not constitute a recommendation to buy or sell the security discussed herein.  The report is an example of the author’s company write-ups / research process; its breadth and coverage may differ materially from other such reports.  Certain statements reflect the opinions of the author as of the date written, are forward-looking and/or based on current expectations, projections, and/or information currently available.  The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term.  The views are those of the author acting in his individual capacity and not as a representative of any firm; in no way does this report constitute investment advice on behalf of any such firm.

Catalyst

Any/all of:

• Controlled unwinding of the Fed's balance sheet / MBS portfolio
• A need for / desire of others to own 'insurance' on higher long-term rates
• Increased inflation expectations
• Economic recession
• Runaway inflation