Arbing Spot And Forward Curve Steepness

On Friday we pointed out that after nearly 9 months of straight line steepening, the Treasury curve, as depicted by the spot 2s10s, has collapsed, and has flattened from 290 to 240 bps practically overnight, in what has been an unprecedentedly rapid move in the curve, driven primarily by asset liquidations. Those with exposure to spot are panicking, and have been forced to cover what amounts to billions in levered notional positions. Some (the lucky ones) only have synthetic exposure, via Constant Maturity Swaps or other Robertson/Klarman-esque contraptions, thus limiting a downside they can walk away from. They are the minority. Yet an interesting observation, coming by way of Morgan Stanley's Jim Caron, who little by little is forced to wave the white flag of surrender not only on his 5.5% call in the 10 year by Year End, but also on his all out steepening trade, is that flattening has really only occurred in the spot curve: forward yield curves, both the 1y and 2y, have surprisingly retained their steepening bias in spite of unprecedented vol and liquidations. Why is this? Caron explains. However, more relevantly, his observation that a convergence between spot and forward curves is imminent could serve as an easy (famous last words) way to pick 100 bps.

From Morgan Stanley:

The fruit of the bond market is carry and the fear of a sovereign risk crisis in Europe is the tree that bears that fruit. The Fed is less likely to hike rates, and as a result, yields are more likely to remain in a range. Traders may look to earn carry in two ways: first, they may buy front-end rates for attractive carry and roll down, since the Fed is not likely to hike until 2011. This trade is particularly attractive for those like us who are worried about a rise in yields once sovereign risks become fully priced. Timing that is difficult, but when it happens, one would not want to have long duration exposure. As a result, earning carry and roll down in the front-end has a better return per unit of risk. Second, for those who are more pessimistic on the outcome of the sovereign risk events and want to position more aggressively with long duration risk, then owning the higher yielding backend of the curve may be more attractive and preferable. Effectively, what this means is that spot yield curves can flatten while forward yield curves steepen on a relative basis. Said differently, we expect a convergence between the spot and forward rate curves – a classic range-trading tactic that allows one to earn carry more safely. This will be the theme of our report this week.

All yield curves are not created equal. There is a difference in the performance of spot and forward yield curves, and it can be said that they serve different masters. We illustrate in Exhibit 1 the performance of the spot US 2s10s swap curve and its 1-year and 2-year forward brethren. Notice that the spot curve has flattened back toward levels last seen in late 2009 and at the start of 2010. However, the forward starting curves have maintained a steepening bias. There are several reasons for this but we will focus on just a few. As we see it, the current flattening of the spot curve is responding to the need to gain long duration exposure and pick-up carry by players such as pension funds and insurance companies, as other risky asset markets are at risk of underperforming. Fear of a disinflation and lower yields brought on by an economic downturn is the master the back-end serves. This flattens the spot curve.

The master the front-end serves is carry. And as bond math would imply, the yields of shorter duration front-end bonds with a smaller DV01 are more sensitive to price and thus to carry. Expectations of economic recovery and Fed rate hikes kept front-end forward rates high, and this is why the forward curves remained so much flatter than spot. What’s different today is that the Fed is expected to keep rates low, thus forward front-end rates are now likely to drop faster and by more than back-end rates.

For example, 1y1y rates have dropped quickly as the market priced out Fed hikes in 2010. We show this in Exhibit 2 where 1y1y rates are approaching all-time lows even from the US crisis in 2008-09. An investor who buys the 1y1y rate and expects the Fed to remain on hold is expecting to capture the roll down between the 1y1y rate and the spot 1y rate. This will have the effect of keeping the forward curve steep. Putting it all together, the forward curve may steepen relative to a flattening in the spot curve. As such our core view remains to hold forward curve steepeners as we like the return per unit of risk that the owning the front-end offers, while hedging it with a short in back-end forward rates. But there are limitations to this view. The risk is that front-end forward rates converge to spot rates and then stagnate – in which case the forward curve would start to flatten. Exhibit 3 illustrates how this might happen: if an extreme divergence occurs between rising 1y Libor rates due to the increased funding risks brought on by the sovereign debt crisis vs. a decline in 1y1y rates driven by the reduced expectations for Fed hikes. The scenario we see for this to happen would be one that prices a significant disinflationary downturn brought on by a severe deterioration in sovereign risk conditions. That is not our base case, and unless we see it otherwise, we will maintain forward curve steepeners and earn carry.

Conclusion: Convergence of spot and forward curves. Current market conditions necessitate that we become more tactical and less strategic in our views. Strategically, we still believe the spot curve may steepen by year-end. But  tactically we prefer to express a relative curve trade of forward curve steepeners vs. the spot curve (Exhibit 4). We achieve this by reversing our long-held short in the T 2s10s30s butterfly, a surrogate curve steepener, while maintaining forward curve steepening exposure (Exhibit 5). More on this theme in the following pages.

Fundamentally, this is a solid trade, although just like Goldman, MS has been struggling with generating any sort of positive alpha for its clients over the past 6 months. Additionally, the MS trade, as Caron admits, is contingent on stabilization in the European contagion and moderation in short-term funding. Alas, this is not our base case. Which is why we anticipate substantial further curve flattening as Libor continues its relentless creep higher. To be sure this will play out in spot, while forward curves may take some time to follow through. Which is we recommend that any convergence arb be sufficiently padded with liquidity should the spot-1y move materially wider than recent highs of 100 bps.

Comments

[Implicit simplicit]

Banks are getting nervous about the debt causing libor to rise along with the risk of lending to each other. They should be nervous. The Euros they are lending against the bad debts of the euro countries will be paid back in devalued euros. This will make it hard for the euro to rise against other currencies in the mid term. The weak countries will nullify any expectations of Euro supporting higher GDP; that is at least until the first US state default threat comes.

[AssFire]

tit curves better than all that bs

[Miles Kendig]

This trade is particularly attractive for those like us who are worried about a rise in yields once sovereign risks become fully priced.

The ongoing rolling multi-sovereign default (temporarily camouflaged as restructuring) combined with the spreading carbuncles of default risk within banking specifically and those areas of finance that accomplish many of the same tasks, especially in Europe renders Jim Caron's concept of "fully priced" sovereign risk problematical at best in the near term.

Meanwhile, finance is going to pump that margin call.  After all, Christmas doesn't come around everyday.  I bet we see more of this kind of nonsense.  Especially now that the need for speed becomes insatiable as the beast dusts off the mega macro pump and dump deployed so successfully through AIG, Bear & Lehman.  

For those who would like to see what carbuncles are.

http://abyssaldepths.files.wordpress.com/2008/04/carbuncle.jpg

[Implicit simplicit]

The default risk looks like staph gone wild. Pizza anyone?

[bulldung]

Given the pump and dump theory of market manipulation, should be a hard week on risk with 4 days of auctions. That the longest is 7year how do auctions weighted to the front differ on their effect to the equity market from longer maturations. If the big buy in SPY on Fri was a resumption of wash, rinse, repeat ;did any patterns emerge in the post 3/09 period that are useful now?