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The Federal Reserve has started to talk more seriously about winding down its second program of quantitative easing (“QE2”). There is now a widespread view that yields on Treasury bonds will rise sharply once the program is over, ostensibly because the Federal Reserve will no longer be “holding the yields down” by buying them. Bill Gross of PIMCO shares this view, and his massive bond fund has
apparently sold all of its Treasury bonds and gone short.

The original argument for the quantitative easing programs was that they would lower interest rates, because the “flow” of purchases of Treasuries by the Federal Reserve would offset the “flow” of new debt being issued by the federal government. The funny thing was that interest rates actually rose across the yield curve in both cases. What that argument failed to account for was the holders of the existing stock of trillions in outstanding Treasury debt perceived the quantitative easing programs to be inflationary, and therefore harmful to their position. They responded by reducing their holdings of Treasuries and purchasing riskier assets. This caused both interest rates and risky asset prices to rise.

The irony is that the consensus used to be that quantitative easing would be bearish for Treasuries. Now, the consensus is the opposite: That the end of quantitative easing will be bearish for Treasuries. Actually, no one need speculate because we have been through this process before, last summer, at the end of the first quantitative easing program (“QE1”). During the period after QE1 ended, from April through August of 2010, the yield on the 10-year note dropped sharply and so did the stock market. The Treasury bears who are so worried about who will buy Treasuries once QE2 ends should rather wonder: Who will buy equities when QE2 ends?

By the way, the reason I mention the Treasury market at such length is that it has become very cheap to purchase an option on falling long term yields (i.e. rising prices of Treasuries). The cheapness or expensiveness of an option is described in terms of an option's implied volatility. Recently, the implied volatility of short term, out-of-the-money calls on a basket of Treasury bonds is around 12%, much
closer to the 52-week low of 9% set just before the May 2010 flash crash, and far from the 52-week high of 22% set in May 2010 after the flash crash.

Low implied volatility indicates a complacent expectation that things – Treasury prices, Federal Reserve policies – will not change very much. It is part and parcel of the complacency which abounds in this market. Implied volatility on the S&P 500 index recently fell to the lowest level since 2007.

I view these call options on Treasury bonds as a very inexpensive way to bet on another spell of deflation or a sudden flight to safety like the May 2010 flash crash. They are also asymmetric: The most the trade can cost is the option premium, but they would be worth multiples of the option premium if Treasury yields fell sharply.