by Rom Badilla
The 10-Year Treasury yield has declined from a recent high of 3.04 percent set on July 15, fueled by signs of further economic weakness. Currently, the benchmark note is trading at 2.88 percent, at or near recent lows. Given the current headwinds which suggest a slowing economy and easing price pressures, the yield on the 10-Year should maintain its longer-term downward trend. However, it may be running out of steam for now. By looking beyond just the charts, there is some evidence that supports this thesis.
The Merrill Lynch’s MOVE Index, which captures option volatility for 1-month options on all On-The-Run Treasuries across the maturity spectrum, spiked higher when bond yields declined significantly in recent months. As the market senses uncertainty and a shift toward a new regime of interest rates via new lows (also works for highs), market participants bid up the price for options to hedge their current risk exposure. Option price appreciation is reflected in higher implied volatility. The main players in this space can range from, but not limited to banks, hedge funds, institutional players, and mortgage originators. For bond gurus, specifically mortgage and derivative specialists, they are often referred to as convexity players.
On May 6, 2010, the 10 Year reached an intraday low of 3.26 percent before closing the day at a yield of 3.39 percent. That same day, the MOVE Index jumped from the prior day’s mark of 95.80 to 116.70, or a jump of 21.8 percent. The MOVE Index increased 5.2 percent to 112.70 when the 10-Year made even lower lows by touching 3.06 percent on May 25. On the first day of the second quarter and after the 10-Year broke the 3 percent range and kissed 2.88 percent in intraday trading, the MOVE Index jumped 4.6 percent to 93.8. (click to enlarge)
In this recent decline in rates where the 10-Year has moved by 16 basis points, the MOVE Index has not followed the aforementioned pattern, suggesting the absence of additional demand for options and hedging needs. Since July 15, the MOVE has increased a paltry 0.4 percent to 78.4 as of last night. While the current theme for slower growth, tame inflation, and lower interest rates is still intact, the recent descent in rates may be running out of steam in the very near term.
In order to make another push to a lower rate environment, the 10-Year may need additional stimulus. A refocus of the European debt crisis coupled with an appreciating dollar will signal fear and a flight to quality. Signs of more price disinflation/deflation or signals of an economic slowdown which should result in a depreciating dollar, will also lead to lower rates. In either case, a new and sustainable regime of lower rates should be accompanied by another significant spike in the MOVE Index.