Why Yields Keep Climbing

Long-term Treasury yields are hanging out near multi-year highs, with the 30-year around 5.25%. Concerns about sticky inflation and swelling budget deficits have outweighed an expanded Treasury buyback program that aims to tamp down borrowing costs. Against that backdrop, traders are bracing for more upside in rates. One sizable recent options position is effectively a wager that the 30-year climbs to about 5.7%, nearly 50 basis points above current levels.

Hedging That Can Turbocharge Moves

When investors buy protection against bond losses, dealers typically take the other side and then hedge their own exposure as rates move. That hedging often means selling Treasury futures or using interest rate swaps that pay a fixed rate, which benefit as yields rise. This kind of convexity or delta hedging can lift swap rates alongside Treasury yields, making the swings larger. "dealers are left with some risk that are hard to hedge," says Shaun Zhou, Interest Rate Strategist at Morgan Stanley. "The solution most likely involves delta hedging along the way."

Mortgage investors add another layer. As rates rise, fewer homeowners refinance, which lengthens how long mortgage bonds stick around in portfolios. To manage that duration extension, investors sell bonds or enter fixed paying swaps, which can add further upward pressure to benchmark yields. "I think of them as independent players reacting to market conditions and they're both decently sizeable," Zhou said. On Sept. 3, Barclays strategists noted that, following years in which the Federal Reserve scaled back its mortgage holdings, "more convexity risk now sits in private hands." They added that mortgage bonds "are likely ending up at asset managers who are more likely to hedge this exposure, making convexity hedging an increasingly important part of the US rates market landscape."

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What Positioning Says Right Now

Options pricing shows where nerves are most acute. In long-end Treasury futures, put protection is still richer than call protection, reflecting demand to guard against a selloff in bonds while 30-year yields hover near 5.25%. By contrast, premiums in the front part of the curve and the belly are closer to balanced.

Positioning has also shifted in cash Treasurys. A JPMorgan Chase & Co. Treasury client survey released Wednesday indicated traders pulled back on bearish bets and moved toward neutral for the week through Sept. 8. Clients cut short positions by six percentage points, pushing overall net longs to their highest reading since November last year.

Inside SOFR Options Flows

The appetite for protection is showing up in SOFR options across Sep26, Dec26 and Mar27:

• The 95.75 strike drew heavy flow over the past week, driven largely by interest in Dec26 puts. That included substantial buying of Dec26 96.00/95.75 put spreads, traded around 12 to 12.5.
• Activity has been brisk at the 96.1875 strike, including 20,000 SFRU6 96.1875/96.25 call spreads at 1.375 and 15,000 SFRU6 96.125/96.1875/96.25 call flies bought between 0.875 and 1. Traders also purchased SFRU6 96.1875/96.25 1x2 call spreads during the week.
• Open interest is most concentrated at 96.25, with significant positions in Sep26 and Dec26 calls. On Tuesday, a large buyer purchased SOFR Sep26 96.25/96.3125 call spreads priced at 0.25, lifting the total to roughly 50,000 by the close. The structure appeared aimed at cushioning a softer CPI on Friday and a possible trimming of Fed hike premium heading into next week's policy meeting.

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