Treasury Yields Surge Above March Spike Highs As Gamma-Selling Kicks In

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by Tyler Durden
Tuesday, Feb 16, 2021 - 11:04 AM

10Y Treasury yields just surged above the spike high level of March...

Source: Bloomberg

Back to its highest since February 2020...

Source: Bloomberg

As Nomura's Charlie McElligott notes, the Bond complex continues to buckle under the guise of the vaccine rollout progress quickening “renormalization” and the eventual release of pent-up demand, with the additional fuel of imminent stimulus release as well - and with it, higher US household disposable income - all-in, creating a powerful backdrop for rising prices (ISM Manu Prices Index largest jump since 2011) and higher inflation expectations (i.e. Friday’s U Mich 1 yr inflation expectations survey at highs since 2014).

The Friday / Monday hard “reflation” impulse which surged through markets occurred at least in-part due to legacy CTA Trend positioning in fixed-income seeing an acceleration in “short” signals, most-notably the prior +93% Long in EUR 10Y (German Bund) “flipping” to the new aggregate -16% Short signal.

Additionally, this acceleration in yields is being driven by convexity, gamma-hedging flows. As Bloomberg's Stephen Spratt notes, Treasuries are at risk.

The break higher in yields may kick mortgage accounts into gear and open the door for convexity hedging flows. Meanwhile, the pop in volatility could bring out gamma-hedgers putting further upward pressure on yields.

Monday’s sell-off, fueled by bunds and gilts, was in high volume. It’s not Treasuries moving on thin air, it’s real selling in futures by perhaps those who bought at the 1.20% level, widely seen as support, or those who took down $41b in new 10-year bonds last week.

So far this year, there’s been no real sign of material convexity paying flows in swaps, though these may come back on the radar now as 10-year yields print the highest levels since March.

What’s more, rates volatility on the exchange has popped. That’s bad news for the legions of program gamma-sellers after there’s already been gamma-tied paying flows in swaps as vol has risen. The latest pop in vol leaves the market ripe for another burst.

The net result: high yields and wider swap spreads. Swap spreads are already wider across the curve, suggesting some savvy dealers may be already anticipating these flows.

Interestingly, net speculative positioning across bond futures has fallen significantly in recent weeks as yields have surged...

Source: Bloomberg

And it could be set to get worse as the historical relationship between 10Y yields and the Fed-sanctified Adrian Crump & Moench term premium of an equivalent maturity, suggests the 10-year yield needs to be higher than 2%, leaving room for plenty of catch-up. (Term premiums - which represent compensation for investors who take on the risk that the yield curve may not evolve as expected - explain almost 65% of movements in Treasuries.)

Source: Bloomberg

The projected value by term premiums is at odds with pricing in the swaptions vol market, which sees less than a 20% chance of the 10-year yield exceeding levels that prevailed at the start of 2020.

And if Nasdaq is to be believed, 10Y Yields should be above 3%!

Source: Bloomberg

The question is 0 who will be right? Will The Fed "allow" rates to go that high?