Rates Traders Reassess Landscape

Terry Flanagan

Many holders of long-volatility positions in interest rates exited trades this week, after Larry Summers withdrew his name from consideration as a successor to outgoing Federal Reserve Chairman Ben Bernanke, and the Sept. 18 Fed update that it won’t yet taper its quantitative-easing program.

“Holders of volatility are realizing losses. They were caught offsides,” said John Brady, managing director at Chicago-based futures brokerage R.J. O’Brien. “The market was ready for a tapering program and was surprised” when it wasn’t announced.

Some market participants say Fed moves are increasingly difficult to predict. “I don’t know how to handicap” what might have been foregone conclusions in past years, one rates trader said.

Meanwhile, “volatility has been directional, following interest rates and yields higher,” Brady told Markets Media, but that trade lost as bond yields dropped this week.

In the short term, Brady expects implied volatility to drift lower, though it could become more profitable again in a medium- to long-term horizon. “Looking to the fourth quarter, the idea is that (10-year U.S. Treasury bond) yields will go higher and they could retest 3%.”

Traders have benefited from increased interest rate volatility in the last few months, which spawned wider trading ranges and more volume.  Amid the fluctuation, put options and put structures gained focus for directional traders who bet that a bear market in bonds would emerge. “There are more macro-type players actively involved,” including institutions, he added.

When Bernanke steps down in January, the new Fed chairman will have to provide leadership to begin the long unwind from five years of monetary stimulus, over which time the central bank bought more than $3 trillion in Treasuries and mortgage-backed securities.

The rise in U.S. interest rates since May has been relatively steep and fast. “The action in derivatives is for the 2-years out and farther” maturity spectrum, one trader said, citing activity in Eurodollar futures options.

The sharp rise has had “a malicious impact on mortgage rates,” Brady noted, concerning the Fed which is not keen to have a slowing housing market weigh on U.S. economic growth.

Institutional clients are keeping a close eye on overnight fixed-rate reversal repos, Brady said. The Federal Reserve Bank of New York announced it will begin testing an overnight fixed-rate reverse repurchase facility as soon as next week as an additional tool to aid policy makers when they begin to tighten monetary policy.

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