Consider the one-month Merrill Lynch MOVE index, a measure of expected volatility in bonds, which plunged to its second-lowest level ever in February. Also, the CBOE’s Volatility Index (VIX) for stocks fell to a six-month low before trade tensions flared up earlier this week.
This sense of calm has been unsettling to some Wall Street experts, who are gearing up for a spike in Treasury yields that rocks equities as well. After all, higher returns on the safest asset class in the world would rein in some risk-taking in stocks.
On Wednesday, investors received a wake-up call to the reality that demand for Treasurys could dwindle enough to send yields flying. At the monthly auction for 10-year notes, bids exceeded the offering by 2.17 times, the weakest amount since 2009, according to Bloomberg data.
Bond yields rise when their prices and the underlying demand for them fall. And recently, Wall Street heavyweights like JPMorgan CEO Jamie Dimon and DoubleLine Capital CEO Jeffrey Gundlach have cautioned investors to be on standby for a jump in interest rates.
“People tend to forecast a little bit of a change, and sometimes it’s a huge inflection point which people almost never capture,” Dimon said on Bloomberg TV. He added that the 10-year yield was “extraordinarily low.”
For Gundlach, who is nicknamed Wall Street’s bond king, this cautionary tale on higher yields extends to the stock market. And the common thread is the low volatility that has ensued in both markets.
The CBOE and Merrill Lynch gauges of volatility are “wickedly cheap,” Gundlach said during a media and client event in New York on Tuesday.
Against this backdrop, the Treasury market faces an unpredictable future that could swing interest rates sharply in either direction, he said. Yields could fall back towards zero if the Federal Reserve remains accommodative enough, but they could spike if demand for bonds continues shrinking.
“We’re in this really weird world where almost anything can happen,” Gundlach said.
He continued: “I could argue for a 6% 10-year in 2021, which I talked about in 2016 when the 10-year was at 1.32%. I could also argue for the 0% 10-year because of the [Fed] manipulation.”
The way forward for investors is to bet that this period of low volatility will not last forever, Gundlach said.
At the Sohn Conference earlier on Tuesday, he recommended options straddles on the iShares 20+ Year Treasury Bond exchange-traded fund. This strategy involves buying put and call options on an underlying security, and it usually profits unless the security’s price remains largely unchanged.
Gundlach said his trade idea will earn at least 40% if interest rates move only 50 basis points at any time during the next year.