US rate options signal market can absorb higher Treasury yields

U.S. 10-year yields `US10YT=RR` topped 5% for the first time in three years last week and returned there on Wednesday following the Fed decision, but rate volatility remained subdued. Analysts and portfolio managers said that reflects an orderly price decline in Treasuries that started with the Fed’s July policy meeting and shows little sign of getting out of hand. "It has actually been a seven-month grind to higher yields," said Chip Hughey, managing director of fixed income at Truist Wealth in Richmond, Virginia. "The speed in which yields have risen, including why we got to these higher levels, really matters. The market tends to become much more uncomfortable when the move really accelerates." U.S. 10-year yields have not sustainably traded above 5% in 25 years, with brief exceptions in 2006 and 2007, and the last approach to these levels came in late 2023 as the Treasury ramped up long-end auction sizes. Options markets are anticipating few fireworks in 10-year Treasury trading even as the benchmark yield has risen steadily this year to 5%, underscoring the role of strong U.S. economic growth in driving rates higher and tamping down volatility. Three-month options on 10-year rates are pricing about 79.5 basis points of annualized volatility `USDSR3MX10YATM=R`, compared with roughly 134 basis points when yields last approached 5% in October 2023. In that episode and two other brief runs to 5% two decades ago, Treasury yields pulled back quickly from 5% as uncertainty in markets and the economy picked up. But traders are far more sanguine about the outlook now, fueling more bets that higher rates are here for longer. Despite widely publicized questions about U.S. debt and deficit dynamics, Amrut Nashikkar, head of derivatives strategy at Barclays in New York, argued that the selloff is being driven less by concerns about Treasury demand and more by a stronger economic outlook. Markets that entered the year anticipating Fed interest rate cuts are now pricing in several hikes and a higher long-run policy rate, he added. If investors increasingly accept that the Fed will keep rates higher for longer, there may be less uncertainty about the direction of policy, analysts said. Rates can then trade in a relatively narrow range around a higher level, keeping volatility suppressed. That said, Nashikkar noted that there has been demand for buying options on short-term rates where most of the uncertainty is about the Fed's reaction function over the next few months. "The market is uncertain about the Fed's next few decisions, but it's not pricing a wider breakdown in the rates outlook," said Nashikkar. "With a Fed that does not provide forward guidance, higher volatility is just a structural feature of the market on a meeting-to-meeting basis." Most of the increase reflects a higher expected path for short-term interest rates, while the term premium – reflecting the compensation investors demand for holding longer-term bonds at a time of uncertainty – has risen far less, Nashikkar said. In other words, investors appear to be concluding that the economy can withstand higher rates than previously assumed. For Victoria Fernandez, chief market strategist and fixed-income portfolio manager at Crossmark Global Investments, strong U.S. earnings have also been a major factor in curbing rates volatility – a fact also reflected in credit spreads remaining mostly narrow and actually tightening among investment-grade technology issuers last week. Earnings growth is expected to run at 25% to 26% over the next two quarters, she said, with corporate profit margins at 17% — "the highest they've been in like 30 years." Combined with a labor market that has avoided broad layoffs, that has left investors willing to absorb higher yields. "I think people go, yeah, we can handle this for right now, as long as it doesn't go on for years."

US rate options signal market can absorb higher Treasury yields

Orderly bond selling keeps stress contained

Options point to subdued Treasury volatility

Growth and Fed expectations are driving the move

Earnings and credit spreads also support the market

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