Are higher Treasury yields coming? Options traders bet yes

NEW YORK: Options investors are positioning for rising Treasury yields, as improving data and rising hopes for a COVID-19 vaccine fuel bets on US economic growth.

The average one-month put-call ratio on the iShares 20+ Year Treasury Bond ETF stands near its highest level since the beginning of the year, according to data from Trade Alert, reflecting expectations that longer-dated bond prices will fall in coming months. Bond yields move inversely to prices.

The bets stem from growing confidence among some investors that the nascent rebound in the US economy will continue, diminishing the allure of longer-dated government bonds while boosting economically sensitive assets such as small-cap stocks, financials and industrials.

A budding US recovery "is giving some asset allocators the idea that it's time to start nibbling at tremendously undervalued sectors," said Arnim Holzer, macro and correlation defense strategist at EAB Investment Group, who has recommended TLT puts to clients. "It's a macro call on a reasonable economic outcome."

The Federal Reserve, which concludes a monetary policy meeting on Wednesday afternoon, has pledged to hold rates near zero for the foreseeable future to help the economy recover from the damage caused by the novel coronavirus pandemic.

While that will likely keep yields on the shorter end of the curve anchored near historic lows, longer-dated bonds may be more susceptible to shifting expectations for inflation and economic growth.

Yields on 30-year Treasuries stood at 1.4174% on Wednesday, up from a record low of 0.702% in March, a move that has been partially driven by gains in the labor market and other evidence of economic healing as well as hopes that a breakthrough on a COVID-19 vaccine is close.

Some investors also see asymmetric risk in government bonds. The Federal Reserve's aversion to negative rates has left little upside in bond prices, said Mark Cabana, head of US interest rates strategy at BofA Global Research. Bank of America's equity derivative strategists have recommended options strategies involving TLT puts.

By contrast, factors like a COVID-19 vaccine and additional US fiscal stimulus could push yields higher, he said.

The bank's strategists also anticipate a rotation into value shares and away from the tech-related stocks that have led markets higher this year. They recommend an options strategy based on the small-cap iShares Russell 2000 ETF outperforming the Invesco QQQ Trust Series 1, which tracks the tech-heavy Nasdaq 100.

The QQQ has climbed 31% this year, while IWM has dropped 6%.

Rising TLT put activity may also be a hedge against a possible change in Fed policy should the recovery gather speed, said Michael Purves, chief executive of Tallbacken Capital Advisors.

"Everyone is convinced that interest rates will be anchored to zero for eternity," he said. "But if we get a vaccine and everything's heating up and it forces the Fed's hand to raise the Fed funds rate, that's going to spill over to the 10-year Treasury."

The central bank's recent decision to allow periods of higher inflation also could pressure longer-dated bonds on expectations that rising consumer prices will erode their value. Recent US economic data showed underlying inflation firming in August.

A steeper yield curve sets up favorable conditions for shares of US banks, which are also benefiting from the vast amounts of debt being issued to support businesses and federal aid programs, said Holzer, of EAB Investment Group. In addition to TLT puts, he has recommended clients buy calls on the Financial Select Sector SPDR Fund in order to benefit from gains in financial stocks.

Banks' "earnings potential could be better than people expect," Holzer said.