Money markets us isnt japan but rate volatility may fall further

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U.S. interest rate volatility has plunged to historical lows as expectations increase that the Federal Reserve may extend its commitment to record low rates beyond its current guidance of 2014. With the euro zone's debt problems continuing to unravel and global economies pointing more and more towards increasingly sluggish growth, U.S. Treasuries yields and volatility may decline still further."If you believe that we are going into a global growth downturn, with incredibly anemic growth globally, then you are looking at multi-year low rates and potentially new quantitative easing," said Mary Beth Fisher, an interest rate strategist at BNP Paribas in New York. For those in that camp Fisher recommends selling volatility through short-to-intermediate-dated swaptions, which are options to enter into interest rate swaps at a future date. These would gain in price value if volatility declines. A worsening economic outlook has increased speculation that the Federal Reserve will launch a third round of quantitative easing later this year, as well as extend its statement that it will hold rates near zero though 2015.

The U.S. central bank said last week that it would extend its Operation Twist program, which involved buying long-dated debt and funding purchases with sales of short-term notes, though the end of the year. Further easing in a deteriorating economic picture would likely send U.S. Treasuries yields to new lows and further dampen rate volatility."Despite the current low levels of volatility, on a relative basis we could go much lower," said Fisher.

To some, the stilted U.S. economy appears to be following the template of Japan, which has seen two "lost decades" of stagnation, deflation and rock-bottom rates. Japan has much lower rates than the United States and shifts in the country's bond yields and interest rate swaps are also more muted, Fisher said. Five-year Japanese swap rates, for example, see moves of around 22 basis points a year while equivalent U.S. swaps may move by over 60 basis points, based on swaption prices.

Two-year Japanese swaps may also shift by only around 12 basis points over one year while U.S. equivalents may increase or decrease by around 35 basis points."To get to where Japan is we would have to get much lower in rates and stay there. We would have to start range trading in narrower and narrower bands, and the moves through those ranges are much less violent," Fisher said. The United States has many key differences to Japan, which has an aging population that poses larger demographic challenges. Japan has also struggled with deflation, which the United States has thus far been able to avoid. That said, the example of Japan shows that even at the U.S. low yields there is still plenty of room to fall further. Fisher recommends selling volatility on options to enter into 10-year swaps in a range of contracts that begin a month from now and extend through to five years.