Harnessing Gains from Yield Curve NormalisationNot too long ago, watching interest rates was as boring as looking at wet paint dry. Not anymore. Interest rates and currencies are as interesting as they get. The US dollar has been clocking moves more akin to an EM currency.
The greenback has been on a rollercoaster ride over the past three months in line with market expectations of Fed’s interest rate policy path. This paper is set in three parts. First, the background to rising rates and spiking yields leads to a brutal bond sell off. Then, the paper evaluates the case for further Fed rate hikes. In the third and final part, it dwells into factors that support a rate pause.
It is not just the rates but also the term structure of rates that’s gone off-the-chart. This paper posits a hypothetical spread trade inspired by the divergence in 30Y and 10Y treasuries with an entry at 13 bps and a target at 40 bps hedged by a stop at 5 bps delivering a reward-to-risk of 1.5x.
RISING RATES AND SPIKING YIELDS
Fed’s commitment to taming inflation with a higher-for-longer stance leads to a surging dollar. Spiking bond yields help reign in inflation through tightening monetary conditions.
The US 10Y Treasury Bond Yields surged to their highest level since 2007, by 20% or 0.8 percentage points since July 17th.
Chart 1: US 10Y and US 2Y Treasury Yields
Yield and Bond prices are inversely related. Surging yields have hammered bond prices lower resulting in a staggering record sell-off. Leveraged funds hold a record net short positioning in US 2-year and 10-year Treasury Futures.
Chart 2: Record Net Short Positioning by Leverage Funds
This brutal selloff has pushed yields to their highest levels in more than 15 years. Among others, portfolio managers and traders can position themselves one of the two ways:
Risk Hedged Yield Harvesting: Harvest risk hedged treasury yield using cash treasury positions and Treasury futures to generate income over a long horizon, or,
Gain from Yield Curve Normalisation: Deploy CME Micro Treasury Futures to engineer a spread trade to realise gains from a normalising yield curve.
In a previous paper , Mint Finance illustrated the first. Distinctly, this paper covers spread trade using CME Micro Treasury Futures.
THE CASE FOR HIKING
The September FOMC meeting re-affirmed a higher-for-longer rate regime. Though there was no rate hike, the updated Fed’s dot plot signalled very different expectations for the rates ahead.
The dot plot was updated to show a final rate hike in 2023 and fewer rate cuts in 2024.
Chart 3: Contrasting US Fed’s Dot Plot between 14/June versus 20/September ( Federal Reserve )
The Fed has adequate grounds to crank up rates even more as highlighted in a previous paper . These include (a) American exceptionalism where the US Economy has been remarkably resilient, (b) Expensive Oil due to geopolitics & receding base level effects, and (c) Brutal Lessons from past on the folly of premature easing.
THE CASE FOR PAUSE
Factors described above have led markets to price another rate hike at Fed meetings later this year. Those views have started to tilt further towards a pause since the start of October as per CME FedWatch tool.
Chart 4: Target Rate Probabilities For 13/Dec Fed Meeting ( CME FedWatch Tool )
Bond yields have surged, helping the Fed with their fight against inflation. Yields on US Treasuries surged to their highest since 2007. As yields are inversely proportional to bond prices, this is the equivalent of a major selloff in the bond market.
Three reasons behind the selloff:
1. Steepening Yield Curve:
Yields are finally catching up to market rates, especially for long-term treasuries; yield curve is steepening
Chart 5: Yield Curve is Steepening
2. Rising Sovereign Risk Premia: The US national debt passed USD 33 trillion and is set to reach USD 52 trillion within the next 10 years. Investors are demanding higher risk premia as compensation for default risk by a heavy borrower.
Chart 6: US Debt to GDP Ratio
3. Higher Yield to Compensate for Scorching Inflation: Investors are demanding higher real rates amid a high-inflation environment.
Chart 7: Real Yields are marginally above zero
Bond yields seem to be peaking. Solita Marcelli of UBS Global Wealth Management opines that the recent upward momentum in yields has been spurred largely by technical factors and is likely to be reversed given the overhang of uncertainty over underlying forces guiding the Treasury market.
Higher bond yields support a case for a Fed pause. This is because rising treasury yields do part of the Fed’s job. Higher treasury yields tighten financial conditions in addition to being a drag on the economy.
The Fed officials shared similar sentiments over the past week:
San Francisco Fed President Daly noted the moves in markets “could be equivalent to another rate hike”.
The Atlanta Fed chief opined that he doesn’t see the need for any more rate hikes.
The Dallas Fed President remarked that such a surge in bond markets may mean less need for additional rate increases.
The Fed has made it amply clear many times that it is data dependent. The data about the economy is positive. And that is concerning. Jobs data last week, and a sticky CPI print raise concerns that the Fed’s hand might be forced to hike despite US inflation being low among G7.
Chart 8: US Inflation is among the lowest within G7s
HYPOTHETICAL TRADE SETUP
Are we witnessing peak rates? In anticipation of the peak, investors can use CME Micro Treasury Futures to harness gains in a margin efficient manner. Micro Treasury Futures are intuitive as they are quoted in yields and are fully cash settled. They are settled daily to BrokerTec US Treasury benchmarks for price integrity and consistency.
As highlighted in a previous paper , each basis point change in yield represents a USD 10 change in notional value across all tenors, making spread trading seamless.
Setting up a position on yield inversion between 2Y and 10Y Treasuries is exposed to significant downside risks from near-term rate uncertainty.
Instead, a prudent alternative is for investors to establish a spread with a short position in 10Y rates and a long position in 30Y rates. The 30Y treasury rates demand a higher term premium due to their longer maturity.
Presently, this premium is just 0.15%. In the past, this premium has reached as high as 1% during periods of monetary policy shifts with yield curve steepening.
Chart 9: US Treasury Inverted Spreads
Furthermore, downside on this spread is limited as the 30Y-10Y premium scarcely falls below 0% unlike the 10Y-2Y premium which has been in deep inversion for the past year. A long position in 30Y Treasury and a short position in 10Y Treasury with:
Entry: 0.130 (13 basis points)
Target: 0.4 (40 basis points)
Stop Loss: -0.05 (5 basis points)
Profit at Target: USD 270 (27 basis points x USD 10)
Loss at Stop: USD 180 (18 basis points x USD 10)
Reward to Risk: 1.5x
Chart 10: Hypothetical Spread (Long 30Y & Short 10Y) Trade Set Up
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
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