I've recently started reading Vince Foster, and I like his articles because he makes good points with an interpretation that differs from mine, and he has much more industry experience than I have.
Here, he talks about the idea that the bond market is selling off as a product of uncertainty from the Fed.
I have floated the opposite theory, here, here, and here. My theory goes something like this:
The rounds of QE have been more effective at creating forward inflation uncertainty, due to the Fed's large balance sheet and duration risk, than at creating actual inflation in real time. In fact, I think this is basically how you might describe the point of QE, in terms of the expectations channel. So, expected inflation hasn't risen much, per se, but TIPS spreads reflect a higher premium due to a wider variance of possible inflation outcomes, depending on the management of the Fed balance sheet. Since this is a risk premium instead of an inflation expectation, some of that premium would bleed into the nominal bond market, pushing all yields down, but with the appearance of lower real yields and higher inflation expectations.
I think the Fed's communication over the summer reduced this uncertainty, and this caused yields to rise (counterintuitively). From a speculatory point of view, back at the beginning of the year, looking at June 2017 Eurodollars with rates as low as 1.6%, this suppression of yields meant that a short position could capture the rising yields as these uncertainties diminished over time. And, the position could be highly leveraged because there was very limited downside risk. These distortions in the yield curve meant that at 1.6%, the final rate for those contracts at expiration could have risen from the current market price even in scenarios where the Fed wasn't raising the Fed Funds rate until well into 2016.
Now, I believe that much, if not all, of this uncertainty distortion has vanished. And what I like about Vince's review of the situation is that it points to a speculative opportunity that I would agree with, even though we are coming at it from two different priors. As he notes, the term spread is as high as it's ever been. He thinks that this represents uncertainty, and I think it represents a reasonable pure expectations yield curve. But, in either case, as long as short term rates are tethered to zero, there is a very strong bungee cord attached to the long end of the yield curve.
I also think there are some naturally mitigating forces on yield volatility that will remain in play during this period of time. The Fed will be hawkish as a balance sheet defense, the propensity of the market to convert currency or bank reserves into inflation will be low as long as we are at low rates, and bank capital would be diminished by further rises in interest rates. And, looking beyond volatility over the lifetime of long dated Eurodollar contracts, I would expect short term rates to top out at less than 3% during this expansion, due to global trends in real rates. That is below the current price of Eurodollar contracts dated 2017 or beyond. The main danger to this scenario would be from unruly inflation coming about as a result a slow Fed response to money supply management as short term rates escape from zero. But, there should be some forward visibility regarding this phenomenon.
For the next 6 months, a position that is short on yield volatility could be leveraged quite aggressively, considering these factors. Or, more specifically, a position leveraged for daily to monthly volatility can be less concerned about pulse jumps in yield or serially correlated volatility that would increase volatility exposure over a longer holding period.