Senior Fixed Income Strategist
Summary: As consensus expects a dovish tapering from the European Central Bank on Thursday, it makes sense to begin shorting bonds ahead of this event. Even if a dovish tapering announcement might not spur massive volatility, we are entering a fragile period for bonds. The selloff is poised to intensify with the German election and a Federal Reserve's tapering before year-end. US Treasuries look even more vulnerable within this scenario than European Government Bonds (EGBs) because the Federal Reserve is clearly behind the curve. Thus, more aggressive tapering will need to follow in the US.
The consensus is for the European Central Bank to begin tapering purchases under the PEPP Program this quarter and be announced as soon as this Thursday. If that were the case, the ECB would lead the Federal Reserve to end accommodative monetary policies.
That would be a clear signal that the bear bond market has begun and that it is time to short Bunds and Treasuries. However, how to do that?
We will talk about that shortly. First, it's essential to understand what is at stake during this week’s ECB meeting.
It's easy to conclude that whatever decision the ECB will take to taper purchases under the PEPP program, it will try to deliver it dovishly. It’s up to the market to interpret whether the dovish framework that the ECB presents is dovish enough. However, if it works, volatility can be contained. Yet, it's impossible to ignore that times are changing fast. Suppose an announcement over the PEPP is not presented now. In that case, it must be tackled in December, adding more pressure on rates, which will be even more volatile following the German election.
Additionally, if a dovish taper is delivered on Thursday, the biggest loser might still be US Treasuries. Indeed, the Fed is falling behind the curve, and the longer it waits to taper, the more aggressive it has to be. That's why this is also the right moment to short US Treasuries.
It is relatively easy to short Bunds and US Treasuries through options. Expectations are for interest rates to rise, thus falling bond prices by the end of the year. If you are long put options, you have the right to sell a bond at the strike price, exposing yourself to a limited downside (premium) and unlimited upside.
In the Saxo platform is possible to browse options by uploading the ticker and clicking on “Option Chain”. The ticker for the Euro-Bund is FGBL, while for US Treasuries, it is ZN.
Let’s take the Euro-Bund option with the December expiry as an example. We like the December expiry because we expect yields to accelerate their rise during the last quarter of the year.
The cost of a put option with delta -0.22 today is of 0.470. Because the size of the option is 1,000, the total premium to put up to buy the put option is 470 EUR.
Similarly, the premium to pay for 10-year US Treasuries put options with a delta of -0.23 is 390 USD.
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