There are many in the market who are surprised by the 56-basis point move higher in 10-year Treasury yields in the month since the September FOMC rate cut. In fact, looking back at the last 30 years of rate cuts by the FOMC, other than the move higher in yields in 1995 after the first cut, the first cut has traditionally been accompanied by moves lower and not higher in 10-year yields. Interestingly, 1995 was a period that was considered a soft landing, the last soft landing the US experienced. Given the market consensus is currently that the US will experience another soft landing, perhaps this move should not be a surprise.

This chart, courtesy of the strategists at State Street, may be telling another part of the story. They looked at the last eight presidential elections and found an interesting trend. In all but one of those elections, 10-year Treasury yields were higher in the 60 days that followed the election. In the one case in which they were not, yields were flat. Thus, over the last 32 years, yields have never been lower in the 60 days that followed the U.S. presidential election. Is this a coincidence? It is only eight data points after all. What the market may be sensing, however, is that the first year of a president’s term, in fact, typically in the first 100 days, is the most likely time for the new administration to push through the policies that got them elected, spending some of the “political capital” that they felt they earned. Could it be that the market is sensing more fiscal spending in the days and weeks that follow?

It may not just be the fiscal stimulus of the new administration that the market is focused on. In this chart, I combined GDP with the budget deficit as a % of GDP. What I want to show is that fiscal spending almost always occurs as a counter-cyclical measure, when the economy is not growing, in order to kickstart it once again. However, after the sharp drop in GDP around Covid, the continued deficit spending, at a time of high GDP, i.e., pro-cyclical spending, has pushed this measure to levels that markets have not seen in the past 35 years. This has coincided with a sharp rise in yields. Looking back through time, when this measure has trended lower, yields have trended lower. When this measure has moved higher, yields have moved higher. Does the current move in yields suggest that not only might markets experience a soft landing, but that markets might also continue to see pro-cyclical fiscal stimulus, regardless of which candidate wins the election?

Traders are placing their bets and doing so in a big way. Above, I show the Commitment of Traders for 10-Year Treasury futures. I look at the leveraged money in particular. What I can see is that the short in 10-Year futures is the largest it has been in over 5 years. Not only are traders bearish futures, they are bearish in a very big way.

In early October, legendary investor Stanley Druckenmiller made headlines at the Grant’s Conference in NY when he said he was shorting U.S. bonds. In fact, he said that short bets against U.S. Treasuries now account for 15% – 20% of his family office’s portfolio. In subsequent interviews, Druckenmiller expressed concerns about the 50-bps cut by the FOMC in September and said the Fed is “trapped by forward guidance.” This perhaps encapsulates the view of other leveraged money traders. For me, given the success Druckenmiller and Soros had in betting against the Bank of England, I also tend to take notice when he expressed big macro concerns.

Turning to technical analysis, I look at the generic front-month Treasury futures in a couple of different daily charts. On top is my preferred ichimoku chart. You can see that futures are breaking below the cloud, the level where the bulls and bears have been trading over the past month or so. This suggests the bears are starting to gain control and we may be seeing a change in trend. If the lagging span (red line) were to break lower, this change in trend could be confirmed. Futures are not yet oversold on a relative strength index (RSI) which is illustrated in the bottom panel of the top chart. In the bottom chart, though, using some different measures, a trader can see that perhaps futures are pulling back to an area where there is good support. The yellow line on this chart is the 1-year moving average and the grayed-out box is the 38.2% – 50% Fibonacci retracement area. This is the area in which one might expect to see futures hold if the move is just a correction in an otherwise bullish trend. If this level breaks, however, there could be considerable downside to the 108 area markets saw back in April and May.

Now I want to look at the volatility markets. My go-to tool to do this is the CME Group CVOL tool. In the top chart, I look at the CVOL Index for Treasury futures and overlay it with the futures themselves. What I can see is that the CVOL has crept up pretty close to the highest levels of the last year. A trader may also see in February of 2023 and October of 2023, sharp moves lower in futures were met with a spike higher in the CVOL.  The bottom chart looks at the level of Skew from the CVOL. This is a difference between the Up Variance and the Down Variance, telling traders whether upside or downside options are favored by traders and investors. One can see in this chart that Skew has been falling, suggesting that there has clearly been a preference for downside options. Not only have the futures developed a large short base, but the options market has bearish action as well.

Digging into the volatility markets a little more closely, my next stop is to look at the term structure of implied volatility so I can get a sense for how traders are pricing one expiration relative to another expiration, as well as pricing calls vs. puts and strike vs. strike within that. The top chart shows the term structure and what I can see is that implied volatility is upward sloping at the front end of the curve up to the TY2X4 contracts which settle on November 8. This date captures a range of economic data but also the November 5 election and the November 7 FOMC meeting.  One can also see this in the bottom chart as implied volatility is upward sloping until that date and then it is mean-reverting after. A trader may also see the preference for downside options vs. upside options in the pricing by delta that the volatility surface graph shows. One thing I would highlight, however. While the TY2X4 contract captures a range of economic data as well as the election and FOMC, CME Group has other Friday contracts that will capture economic data that will potentially not only impact the FOMC meeting but could well convince traders of the impending course of action, well before the actual meeting. The TY1X4 contract settles the Friday before, November 1, and this contract will capture the next nonfarm payroll number as well as the PCE data, the Fed’s preferred measure of inflation. Given the FOMC has a dual mandate of full employment and stable prices, by November 1, the market may well have a good idea what the FOMC will do. This could mean that the only uncertainty between the Friday, November 1 contract and the Friday, November 8 contract is the presidential election.

In order to see how much volatility the market is pricing in for the U.S. election, I turn to the Event Volatility Calculator from CME Group. By using this tool, and putting in the date of the election, I can see what volatility can be backed out of the pricing in the market. Above, the calculator tells me that the market is pricing a 22.7% implied volatility for the U.S. election, even though the levels for implied volatility surrounding that date are much closer to 8%. This tells me that, perhaps, there is too much volatility expected for the election itself.

Using this information, I decided I want to express a view in which I sell the November 8 options and cover my risk buying November 1 options. This provides protection in the event the economic data are the catalyst for movement in futures. Because I am selling a considerably higher implied volatility, I am able to buy a November 1, 111 put, and sell a November 8, 110 put, and do the entire spread for zero cost. This means that I have a bearish put spread on for the next 11 days and have it for no cost to me. If traders continue to press their short bet on the technical break of futures, the spread has short exposure that will profit from the move. If the economic data comes out and suggests a more dovish FOMC is expected, leading to a short-covering rally in futures, the spread loses no premium provided the move comes on or before November 1.

The risk comes from the decision that needs to be made at the November 1 expiration as is always the case with calendar spreads. What will happen with a bigger move in one direction or another?

In order to assess this risk, I ran two simulations. In the first simulation, I look 10 days ahead and see what the spread is worth if futures are much lower, in this case at 109.16, well below the strikes of both options. In this scenario, you can see that the spread has moved from zero cost to 22 ticks in my favor. If this move were to happen, even though there is a large amount of premium in each option, I can choose to close the spread and take a nice profit.

In the second scenario, I also look 10 days into the future and see what happens if futures move higher, well above each strike, at 112.16. In this scenario, I am now down some money, about 3.6 ticks. While the 111 put I am long still has a higher strike, we are much closer to the option expiring worthless. The November 8, 110 put, with its longer time to expiration, holds onto more of its volatility value. However, in this worst-case scenario, I have only lost 3.6 ticks.

Looking at the reward-to-risk from this simulated analysis gives me more comfort that I have an attractive risk profile for this spread. However, this is a spread that needs to be closed at or before the expiration of the first option – the TY1X4 111 put – otherwise the risk nature of the idea completely changes. This spread is for the trader that's willing to actively manage their risk.

Using all of the tools available to a trader from CME Group – Event Volatility Calculator, CVOL Index, implied volatility term structure and QuikStrike spread builder – one can identify where there may be opportunities for a trade, how one might one to express their idea and then how that idea may perform over time. This creates an ideal opportunity to find asymmetric reward-to-risk trades to add to a portfolio.

Good luck trading!

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