DAVID WOO: There’s Only One Market In The World That Really Matters Anymore

Anyone who has been following global financial markets over the past month or so will have easily flagged the sell-off in the U.S. Treasury market as a major event that has been felt around the world.

Even more important than the price action in Treasuries itself, though, is how volatility in the market has risen.

The chart below shows the percentage increase in both Treasury yields and volatility of Treasury yields since the beginning of May, when the big sell-off in the bond market began.

Since May 2, yields have risen 34%, while volatility is up 64%.

Treasury volatility vs yields

“Everybody knows that at any given moment in time, there is usually one market more important than all the others – the one that sometimes becomes the principal driver of all other markets,” writes BofA Merrill Lynch rates guru David Woo in his latest note to clients. “Price action over the past month tells us that US rates, especially US rates vol, has become that pivotal market.”

Why has the Treasury volatility market become so important?

Woo argues that “carry trades love low risk-free interest rates, but they love low interest rate volatility even more.”

“This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels,” writes Woo. “This is also why with the back-up in rates vol triggered by talks about the tapering of QE, these assets have witnessed a sizeable correction over the past month.”

According to Woo, there are three reasons interest rate volatility could be set to move higher in the Treasury market:

Despite the recent spike in rates vol, it remains at a low level. Both our macro-vol model and our walk-vol model suggest that 10y rates vol is undervalued. The breakevens on rates straddles also seem too narrow – the implied range for a 3m 10y rates straddle is 1.8-2.3%.

Increased positioning in US rates could push rates vol higher. Investors have built up considerable long positions in both the US dollar and US equities, reflecting growing optimism about the US. In contrast, positioning in US rates appears unusually light. It seems reasonable to assume that rates positioning has room to play catch-up, if only for hedging purposes. Increased demand for convexity hedging can also push US rates vol higher. We believe many mortgage investors are under-hedged.

We don’t see the May NFP significantly changing the tapering speculation. The modest increase in the unemployment rate may lead the market to push out a little further the start of the Fed rate hiking cycle, but the healthy pace of job creation does not weaken the case for tapering, in our view. We have been surprised and impressed by the resilience of the US recovery to both fiscal tightening at home and the slowdown abroad. In any event, we suspect the rates outlook has become more asymmetric: rates will likely react more to strong data than to weak ones, at least in the short-term.

10-year U.S. Treasury yields continue to rise today. Right now, they’re up about 3 basis points, trading at 2.20%.