why would the vol explode if the steepening of the curve is mostly the result of the treasury's issuance strategy - involving a shift towards longer maturities compared to 99-03 era - as per attached slide 8? or do you believe the market won't buy that easily and TIPS spreads & other related inflation expectation type indicators are all going to jump at the same time? just wondering...
From Bill Power's interview on Pimco website: "Q: PIMCO has traditionally been a seller of volatility based on the notion that actual volatility tends to be less than the market expects over the long term. How does PIMCO now express its view that volatility is likely to increase over the secular timeframe? Powers: The best way to reduce exposure to volatility in a portfolio is simply to sell mortgage-backed securities and move into fixed income securities that do not have the option characteristic embedded in mortgages. We have already done some of that ... We have historically employed options strategiesâselling straddlesâas a method of selling volatility to garner extra income in portfolios. In the future, we expect these strategies to be much more modest in proportion. In fact, if volatility continues to decline, PIMCO could buy straddles or employ other strategies to buy volatility rather than sell it." http://www.pimco.com/LeftNav/PIMCO+Spotlight/2006/Spotlight+Powers+06-2006.htm
The setup I was waiting for is starting to take shape. While the 30 yr bonds are going up because of the Fed's constant reminders of its commitment to keep inflation under control, shorter maturities are showing a lot of resistance to follow. Longer maturities are also going up because the inflation risk premium that was building up in March and April turned out to be exagerated: The Fed's early warnings that the second quarter was going to be weaker than the first quarter were confirmed by data released during the months of May and June during which period the risk premium melted with the result that the yield curve is now flat again. Recently, gold, stocks and the dollar have been reflecting the Fed's stance on inflation while oil stabilized. It stabilized but with the threat of springing back as soon as economic data and stock indices would show strength. Now, that I'm starting to see some additional signs of weakness in oil prices, I'm starting to anticipate the moment when bonds accross all maturities will resume their downward trend with little resistance. It might take one or two more weeks before this happens. In the meantime, oil should go back to $68, trigger a stock market rally, and then bonds will be in sync to price in economic strength and tight monetary policy. This is my roadmap for now to get to my next trade.
I'm happy with my position, for now... I think resistence to 110 will be heavy, and it may take a blow off top on little volume to make it happen. Either way, bonds are finally starting to act as they used to: Stocks go down --> Bonds go up... Ah yes, remember that correlation? We've had a decade now where both went up simultaneously...
Everyone is talking about worries over inflation, but it seems that the worries are over liquidity problems. The very strong short covering in the dollar shows that leveraged accounts are hurting (I think the US is the last place they really want to be invested). In a de-leveraging environment long duration assets (both stocks & bonds) could get hit very hard. Until we get a meaningful widening of interest rate spreads it favors shorter duration products.
except the treasury is going to shift issuance towards longer maturities.... that's the supply-side of the equation... take or leave...
So how much inflation is now priced in? If we get just "as-expected" CPI, will bonds jump higher? (and stocks too?)
I prefer to be on the sidelines for a few more days but if I HAD to make a bet I would bet that prices are about to surge and peak shortly after. Recent price movements, in the light of incoming events such as tomorrow's Beige Book and Fed talk Thursday and Friday, are announcing a big move by the end of the week but with no clue on the direction of that move. Since global market conditions have been <i>extremely</i> favorable for bonds during the past week and a half, I would bet that the direction is up.