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More On The Perplexing Record Steep 10s30s Curve: Is It (Finally) Time For Flattening?
After recently the market took all calls of a flattening in the 10s30s to task, one would think that those anticipating a curve flattening (Zero Hedge included) would finally have learned their lesson. This has not happened so far, especially since a continued sell-off in the long-end will soon move from being a boon to the curve carry trade, to a flashing red signal of inflation expectations which will likely wreak further havoc across all asset classes. Also, quant models are already on the edge of refusing to bid up the 7 and 10 Y even as they are forced to sell 30Y, no matter what the Fed is telegraphing it will do. In his attempt to anchor the curve around the belly, Brian Sack has let the 30Y flail in the gusts of increasing inflationary expectations, and quite soon the plan will backfire. Which is why we believe that with future POMO schedules, the FRBNY will disclose an ever greater portion of monetization in the 17-30 Y segment, over and above the 4% disclosed originally on November 3. One analyst who refuses to give up on the flattener trade is Morgan Staney's Igor Cashyn, who as of Friday, has reiterated a call for imminent de-steepening, although unlike before where the flattener was to be traded via nominals, this time the Russian goes straight into Real Yields.
From Morgan Stanley:
In our mid-October piece, we recommended entering into a UST 10s30s flattener, beta-hedged with a UST 2s5s flattener to hedge the risk of UST 10s30s steepening further if Fed hikes were to be pushed out further in time (see Treasuries: A Modest Back-Up In Rates As Market Awaits Direction on QE2, October 14). Our reason for entering the trade was that the 10s30s curve was too steep versus 2s5s, a residual that was driven by the 10s30s real yield curve that was running ahead of 2s5s. The risk to our 10s30s nominal flattener call was that inflation fears would rise and lead to a steepening of the 10s30s breakevens curve, and in a separate trade we has recommended hedging this view via a 10s20s breakeven steepener, also published in the same mid-October piece.
Over the past several weeks, however, the main driver of the UST 10s30s curve has switched from the real yield curve to the breakevens curve as UST 10s30s steepened to a new all-time high of 159bp (Exhibit 1), and while our 10s20s breakeven steepener hedged most of this underperformance, we now look to simplify our original trade:
The main catalyst that has raised Cashyn's suspicions about ongoing bidding at the long-end is that currently a regression analysis finds that the 10d30s is 16 bps too steep, not to mention at record wide levels.
We therefore roll our 10s30s nominal flattener into a 10s30s real yield flattener, but still hedge the Fed risk with a 2s5s nominal flattener. That is because when we run a 6-month regression of 10s30s real yields on 2s5s nominals, we find that the 10s30s real curve is still 16bp too steep (Exhibit 2), but we think there is good scope for it to flatten as it has recently had problems steepening further. In determining our hedge ratio, our regression shows that the 10s30s real yield curve moves 0.7bp for every 1bp in 2s5s; thus, we recommend that for every one unit of dv01 that investors put on in a 10s30s real yield flattener, only 70% of the dv01 risk is put on via a 2s5s flattener (Exhibit 2).
We tend to agree with this assessment, especially since as we have disclosed there is little that is left to the left of the 10Y in net issuance that can be purchased, with the notable exception of Bills of course. Which is why we think that as the market attempts to front-run Sack's next trade, the focus will increasingly shift ever to the right. What we believe will be the catalyst will be a piece out of Goldman calling for the outright selling of the long-end. Recall that it was Goldman's call in the week ahead of QE2's announcement, for Fed buying in the 17-30Y bucket, that allowed the firm to sell billions of in kind notes to clients. Soon, it will have shorted enough, and the time to cover will come. Keep an eye out for the signal. As of now, Francesco Garzarelli is still telling clients to buy.
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At some point is it possible that this dramatic price action in 30yrs
ends up blowing up the mountain of IR swaps at Dimon and company?
IRS is based on future discounted cash-flows of a risk-free rate (LIBOR), not treasury yields.
Most IRS notional is at the front-end of the curve.
This implies there is no intrinsic connection there.
Because there is a conceivable but crazy arb relationship, there is a connection through a possible basis trade. At the long end, it would be like making a deal with the devil.
thanks for the clarification, assuming you are the same jm who wrote "a swap spread puzzle" i love your work.
Yes.
Boom.
http://www.youtube.com/watch?v=zsTRxXvQY0s
In other words, Bernanke will have to shove QE2 up his proverbial asshole.
Looks like it:
Lacker Says Fed May Need to Increase Rates Even With Elevated UnemploymentFederal Reserve Bank of Richmond President Jeffrey Lacker said the central bank may need to tighten monetary policy even with the U.S. unemployment rate elevated to avoid a surge in inflation similar to the 1970s.
“At some point in the not-too-distant future, we are likely to face an economy growing in a self-sustaining way while the unemployment rate is still relatively high by historical standards,” Lacker said today in a speech in Richmond, Virginia. “The decisions we make at that time will be the true test of whether we’ve learned our lessons.”
I'm glad that was the first sentence, it saved me the time to bother reading the rest.
Isn't the Fed going to have to eat these at some point?
If rates go high, doesn't the Fed take a loss of giagantic proportions?
Isn't the face value loss on low rates disproportiantely large/huge/massive/i.e. Jupiter sized?
Ouch, me so hurt.
If rates go up, then the value of all the FI on the Fed's Balance sheet would go down, but only if sold before maturity.
Is It (Finally) Time For Flattening?
Now that is definitely going to hurt.
Whatever the outcome....
GS and JPM will be pre-positioned to profit from it and will make vast profits.
As usual........
Wash, Rince, Repeat....
No doubt stylish one
Exactly. The Fed cant be bothered with old world issues such as the Yield curve and other boring topics such as that. Its all about pumping the markets , POMO and how many positive trading days GS has. The rest is just stuff the Feds special Bond computers handle. Flattening? Nothing the Feds printing press couldn't handle. Besides, Do you really think anyone at the Fed even knows what a yield curve is?
what is the curve for "real" yields and where do i find it?
nevermind, fyi: http://www.ustreas.gov/offices/domestic-finance/debt-management/interest...
15-20% firmly beyond the 10yr by the end of June 2011 still holds. Meanwhile ya just gotta love how the pure expectations game is gettin' pumped and churned like some BL sushi prop .. (When will the folks at 33 Liberty learn about wasabi, besides on their nuts that is?)
http://www.bluediamond.com/index.cfm?navId=42
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a PHONE call between "THE BEN BERNANK" and ZHOU of PBoC :
http://www.lewrockwell.com/north/north906.html
i liked these few lines :
"
Zhou: We can figure. Gold is over $1,350 an ounce. The dollar has been falling. We think the older mercantilism was right. We want to own more gold.
Bernanke: You can’t eat gold!
Zhou: We can’t eat T-bonds, either."
Ah too bad, bad guys. The best laid plans of mice and men...
never really alchemists stumble their minds upon bedding Gold.
Light > Gold
So Howard Roark, Ender and Isaac Newton walk into a bar
because it's not that far.
Brian Sack is like the little Dutch boy with his fingers (and toes and other body parts) trying to plug all the holes in the proverbial dike. At least the old Soviet USSR Marxist Politburo central planning model was efficient, this Tim&Ben charade is becoming embarrassing.
Yeah right, Tyler... this curve flattening crap has been supported by you for a long time and proven disastrous for the bond longs. How about the fact that muni market is imploding and that the USA is bankrupt ansd systemically falling apart. A bankrupt USA cannot have a flat yield curve.
Contrary to the recent vote on ZeroHedge, the Long End of the Curve will be tackled next by the Fed. Why? Because they can't afford to let investors get any ideas about higher rates. Secondly the Federal Government is ALREADY bailing out Municipalities via Bond Purchases. See Meredith Whitney's piece on the subject:
http://dollarcollapse.com/uncategorized/will-bailing-out-the-states-kill...
Besides since the Fed is going to buy Treasuries of whatever maturity they are in a sense bailing out the states by providing Liquidity to the Treasury who in turn gives it to Congress who it turn gives it to the States.
Second that. The long end offers cheaper bailout financing the way I see it.
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