Paging Felix Salmon

Or someone else who is equally on top of the bond market.

[UPDATE: an anonymous commenter quickly backed some market values out of the swaptions market. Bravo! I’ve added the commenter’s calculations to the table below, which only had the first two columns when I first wrote it.]

My problem is this. Suppose you ask me to predict what the 10-year nominal Treasury bond rate will be four years from now. I would give you this probability distribution:

What this table says is that I think that there is a five percent chance that the ten-year will be at 2 percent or less four years from now. Call that the Roubini scenario, because it means we are in one godawful recession. I think there is a twenty percent chance that the ten-year will be at 3.5 percent or less. I think there is a fifty percent chance that it will be at 6 percent or less–based on something like an expected inflation rate of 3.5 percent and a real rate of 2.5 percent. I think there is a twenty percent chance that the ten-year will be at 8.5 percent or more, because of all the debt we are running up. And there is a five percent chance that we will see double-digit interest rates, again because of all the debt we are running up.

What I need Felix to do is find the best yield curve data and the best estimate of implied volatility and back out what the market thinks these probabilities are. [commenter did this]

My guess is that the market is skewed much lower than I am, both in terms of the expected value of the ten-year and in terms of volatility. What that means is that I should be buying puts on long-term Treasuries. One way to sort of do that is to take out a mortgage on my house. But I think I an be persuaded that the transaction costs on doing that outweigh the tax benefits, so that puts on Treasuries are the way to go.

[Based on commenter’s numbers, I was right about the expected value, but I am not so right about the volatility. There’s roughly as much implied volatility in the market as there is in my numbers. What that says is I should not be buying puts so much as just flat-out shorting Treasuries. As another commenter points out, there is an exchange-traded fund, TBT, that does that. I should emphasize that (a) the point of this blog is not to make investment recommendations; and (b) I have not put any of my own money into TBT, as of this date.]

My larger question is: what is the market thinking? Ordinarily, when I disagree with the market, I assume that I am the one who is stupid. But I have a hard time drawing that conclusion right now. Is there anyone out there who can tell a persuasive story to justify the current Treasury yield curve and implied volatility?