This morning the US markets awoke to news of terrorist bombings in Brussels. The normal reaction to unexpected news that could produce negative economic activity is one of flight to quality. Simply said, we see a shedding of riskier assets (stocks) combined with movement into the relative safety of Treasury notes/bonds. The decision to protect assets is usually an automatic reaction to significant, market disrupting news; deciding when it is safe to wade back into riskier assets though can be difficult to gauge. By viewing the volatility skew for options on treasury bond futures, you get a picture of flight to quality forces in effect and and when they wane.
Be careful when the bond skew smiles.
When charting volatility for options on bond futures, a normal skew will be generally downward sloping, with out of the money puts trading at a higher volatility than similarly out of the money calls (X-axis = strike price / Y-axis = implied volatility). During flight to quality moves the market experiences concentrated periods of buying in Treasury bonds and their related futures contracts. This need to be long the bond market is often expressed conditionally through the purchase of out of the money call options. Since flight to quality action enters the market rapidly as participants seek security, traders’ main concern is the accumulation of safe assets and not the volatility price component of call options. When such concentrated buying of call options occurs, their implied volatility is pushed outside normal relationships. The pictorial representation of the bond skew under flight conditions resembles a smile, with both out of the money puts and calls trading at higher implied volatility levels than the at the money strike. The chart below is May options on June bond futures (USM) created on Bloomberg’s OVDV function. The chart’s white line depicts this morning’s flight produced skew, whereas the red line shows Friday’s more normal skew.
Bond skews can monitored throughout a flight to quality event to determine ongoing market need for protection. Should the skew’s smile become more pronounced, the market is perceiving a continued (or greater) need for asset protection. As bond futures implied volatility skew flattens to a normal look, most protective moves have now been represented and riskier assets can be entertained once again.