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January’s surprise rally in Treasuries may prove fleeting, as options traders bet on bigger price swings in bonds and waning volatility in stocks for the first time since 2006.

Barclays Capital indexes show interest-rate volatility rose from a six-month low in November on speculation borrowing costs will increase as the improving economy allows the Federal Reserve to remove the unprecedented cash it pumped into the financial system. At the same time, confidence in the outlook for profits helped push the Chicago Board Options Exchange Volatility Index to an almost two-year low this month.

The correlation was negative in 2006, the last time policy makers were increasing the target rate for overnight loans between banks. Yields on 10-year Treasuries increased 0.75 percentage point in the first half of that year, sparking a loss of 3.9 percent, according to Bank of America Merrill Lynch indexes, while the Standard & Poor’s 500 Index rose 1.8 percent. Fed officials meet this week to discuss monetary policy.

“We’ve probably seen the great secular bull low in yields,” said Mitchell Stapley, who helps oversee $13 billion of debt as chief fixed-income officer for Fifth Third Asset Management in Grand Rapids, Michigan. “Earnings don’t seem to be a concern on anyone’s plate right now. The level of rates, what happens in the housing market, that’s on the forefront of people’s minds and why we are getting fixed-income volatility spikes that haven’t made it over to the equity markets.”

Bond Rally

The benchmark 10-year note rallied last week, driving the yield down to 3.61 percent from 3.68 percent on Jan. 15 and 3.84 percent at the end of 2009, according to BGCantor Market data. The 3.375 percent security due November 2019 rose to 98 3/32 on Jan. 22 in New York from 97 16/32 a week earlier. The yield rose to 3.62 percent at 1:05 p.m. in New York.

This month’s gains run counter to forecasts by the 18 primary dealers of U.S. government securities that trade directly with the Fed. In a survey by Bloomberg News at the end of last year, they predicted yields would rise to 4.14 percent in 2010.

Bonds rose after government reports showed retail sales and housing starts unexpectedly declined in December, calling into question the strength of the recovery. President Barack Obama’s plan to limit the size of banks also raised concern that growth may not accelerate as forecast.

Boosting Forecasts

Investors “sensing a lot of market and regulatory uncertainty, have felt compelled to seek the safety of U.S. government debt,” Kevin Giddis, head of fixed-income sales, trading and research at brokerage firm Morgan Keegan Inc. in Memphis, Tennessee, wrote in a note to clients last week.

Signs of weakness didn’t prevent the World Bank in Washington from raising its forecast for global growth this year to 2.7 percent, from a June estimate of 2 percent. The economy may expand 3.2 percent in 2011, the bank said.

“Is 2010 the year you are going to get the shift from stagnating growth to growth? I don’t know, but I am going to position myself for that,” said William Larkin, a fixed-income manager at Salem, Massachusetts-based Cabot Money Management, which oversees $500 million.

Some Fed policy makers are more confident, giving urgency to discussions about how and when to pull back from record-low interest rates. Government data show business inventories are increasing as companies try to keep up with rising sales.

Market ‘Healing’

Kansas City Fed Bank President Thomas Hoenig said Jan. 11 the central bank should end purchases of mortgage-backed securities because the market is “healing.” Philadelphia Fed Bank President Charles Plosser said the next day that the recovery is “sustainable even as the fiscal and monetary stimulus programs eventually wind down.”

Fed officials, who start a two-day meeting on Jan no fax payday loan. 26, repeated a pledge last month to keep rates near zero for “an extended period” and said more stimulus “might become desirable.”

The central bank will keep its target rate for overnight lending among banks unchanged at its current range of zero to 0.25 percent through September and raise it to 0.75 percent in the fourth quarter, according to the median forecast in a Bloomberg News survey of economists.

‘Complete the Symmetry’

“We are looking for a quiet first half volatility story for bond yields to be shattered by a relatively early and potentially erratic start to the Fed tightening cycle some time around mid-year,” said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “The Fed brought down short-term rates with record speed in this recession, and is likely to complete the symmetry on the upside raising rates potentially as fast as they came down.”

Stock investors may see higher Fed rates as a signal the banking system and consumers are on more solid footing, said Tim Freeman, head of U.S. equity derivative sales in New York at Capstone Global Markets LLC, which specializes in volatility trading.

“You could see interest rate volatility continue to go higher as expected rate hikes are priced into the marketplace, while in the equity market you might not see any uptick in volatility,” Freeman said. “You could actually see the equity market react very positively to the Fed raising rates.”

Volatility Correlation

Volatility in options on U.S. interest-rate swaps as measured by the Barclays Swaption Volatility Index rose as high as 114.55 basis points after touching a six-month low of 104.49 on Nov. 25. The index finished last week at 108.05 basis points. The VIX, as the Chicago Board Options Exchange Volatility Index is known, fell as low as 16.86 this month, from 31.84 in November, before rising last week to 27.31.

The correlation between the daily percentage changes in each index was minus 0.11 on Jan. 21, based on the most recent data available. That compares with a peak positive correlation in the last five years of 0.5976 in March 2007, just before credit markets began to seize up.

“As speculation on the Fed mounts, as you get into the third and fourth quarter, it will result in even higher interest rate volatility,” said Moorad Choudhry, head of Treasury at Europe Arab Bank Plc in London and the author of “Structured Credit Products: Credit Derivatives and Synthetic Securitisation.” “We expect the Fed, when they begin, will raise rates relatively quickly.”

Swap Rates

In a swap, two parties agree to exchange fixed for variable-rate interest payments based on a benchmark index such as the London interbank offered rate, or Libor, over a set period. Swaptions are options on those swaps. Movements in swap rates, usually higher than Treasury yields, typically mirror trends in Treasuries.

The end of the Fed’s purchases of mortgage bonds, scheduled for March, should create more volatility and boost Treasury yields, said Carl Lantz, an interest-rate strategist in New York at primary dealer Credit Suisse Group AG.

The program was designed to keep longer-term rates down to support a rebound in the housing market. Ten-year Treasury yields were less than 3.2 percent in October, when the central bank completed a $300 billion Treasury purchase program.

“That hand-off has everyone in the bond market quite concerned,” Lantz, who forecasts 10-year yields will rise to 4.25 percent before falling again, said in a Bloomberg Radio interview on Jan. 5. “Animal spirits will swing back and forth. This will be a very choppy year for yields.”

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