The Treasury Bond Market Could Get Ugly Between Now And September 19

The Treasury market has cooled off substantially since the epic sell-off and attendant rise in yields that sent volatility soaring to multi-year highs in May and June as traders have left Wall Street for summer vacation and trading volume has fallen to its lowest levels since Christmas break.

The chart at right shows the yield on the 10-year Treasury note in blue and volatility in the Treasury market – proxied by the Merrill Lynch Option Volatility Estimate ("MOVE") Index – in red.

Since the last big move upward on July 5, 10-year Treasury yields have traded in a range between roughly 2.5% and 2.7%, while volatility in the market has fallen 36%.

Meanwhile, trading volume has cratered, as the chart below illustrates.

However, volatility in the Treasury market is set to rise again in the coming weeks, according to strategists at BofA Merrill Lynch, who warn clients in a note over the weekend: "Don't get lulled by the summer doldrums."

"As investors escape to more relaxed environs, it is easy to think that the next several weeks will be relatively quiet ones for financial markets; we urge caution," says BAML technical strategist MacNeil Curry. "A seasonal analysis of our MOVE Index (aka the Merrill Option Volatility Estimate) says that fixed income implied volatility tends to jump sharply during August. With the recent range in U.S. Treasury yields growing mature and poised to complete (we continue to target 2.85%/2.95% in US10s), the potential for fixed income implied volatility to hold to its seasonal norms is too high to be ignored."

In a separate note to clients over the weekend, BAML credit strategist Hans Mikkelsen issues a similar warning:

While straight line increases in interest rates make sense as forecasts, it goes without saying that in reality interest rates will at times overshoot and undershoot these forecasts. As credit strategists we are especially concerned about the overshoot scenario in the short term - in particular between now and the September 19th conclusion of the next FOMC meeting for three reasons.

First, we are currently experiencing upside surprises to economic data as highlighted by the spike in Citi's economic surprise index. Second there is significant communication and implementation risk associated with the coming QE tapering. Third, as our interest rate strategists have pointed out repeatedly ... unlike over the past several years, it is not clear who is going to step in and support Treasuries this time, should they sell off further.

Mikkelsen elaborates on that last point, questioning who could step in to support the market in the event of another sell-off:

Since the financial crisis, Treasuries have been supported by numerous types of investors, including mutual funds/ETFs, banks, [emerging market] central banks and the foreign official sector (in addition to the Fed of course). However, these four sources of Treasury demand are unlikely to support the market in the short term going forward.

First, with continued outflows from non-short term high grade bond funds, money managers are unlikely to provide support for Treasuries any time soon.

Second, with increasing loan demand reducing the need for banks to support profitability by buying Treasuries, as well as significant mark-to-market losses in [available-for-sale] portfolios that in the future will count against capital, banks are unlikely to add long-duration assets in a rising interest rate environment.

Third, in light of continued depreciation of [emerging market] currencies, it appears unlikely that [emerging market] countries are experiencing inflows that need to be reinvested in Treasuries.

Finally, custody holdings of Treasuries continue to decline, suggesting foreign official sales of Treasuries.

Put everything together, and the stage may be set for another spike in volatility between now and September 19.