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Treasury Curve Flattest Since May 2009 At 227 bps, Morgan Stanley Dual Digital CMS "Deflation Hedge" Trade Well In Money

Tyler Durden's picture




 

One word how mortgage originators and funding desks feel right now (not to mention Morgan Stanley bull steepener clients): Panic. The 2s10s is now at the flattest it has been since May 2009 and going lower. All leading indicators (such as the Conference Board's, see the musing from the FRBSF yesterday on the topic) that use the flatness of the Treasury curve as an input variable are about to have a heart attack, further indicating the deflation is coming, in turn further pushing the yield lower. Ironically, those who followed Morgan Stanley's recent deflation hedge trade recommendations (1 Year dual digital out 100bp in one year if 2y CMS is below 0.8% and 30y CMS is below 3.3% at expiry for 16.5bp; and the 1y 1s5s conditional bull flattener, for zero cost, struck at 126bp. Currently, the spot 1s5s curve is at 130bp) are well in the money.

 

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Tue, 08/10/2010 - 10:17 | 512478 PlausibleDenial
PlausibleDenial's picture

Jesus, wtf does all that mean... And, you wonder why the retail investor takes it the ass.  I am just too stupid to get that trade.  Oh, and when I grow up I wanna be a trader... GEEZZZZ

Tue, 08/10/2010 - 10:43 | 512529 KevinH
KevinH's picture

Take a look at the normal yield curve from 1 month T-bills to 30 Yr Bonds. The yield curve is generally upward sloping, meaning longer term bonds have a higher yield; this makes sense logically as you are compensated more for holding them longer (and with inflation, you need this higher yield farther out onto the curve so your money doesn't lose value).

The 2s10s is simply the difference in yield between the 2 yr and the 10 yr bonds. 2s10s flattening simply means that the yield between the 2 yr and 10 yr are getting closer to each other. If the 10 yr yield = the 2 yr yield, or worse, the 10 yr yield < 2 yr yield (inverted yield curve), then the market/economy is in trouble. Remeber that yield is simply (bond's coupon)/(bond price). The 2s10s will flatten only when demand for the 10 yr bond is so high, that the price is driven up, thus increasing the denominator in the yield formula, and drive down yield.

Now, ask yourself, in what situations would you be willing to accept a 3% return on a 10 yr bond when there is a 4% return on a 2 yr (the inverted yield curve situation)? Go with the extreme situation of an inverted yield curve and you will see why a flattening 2s10s signals recession, and deflationary scenarios.

Tue, 08/10/2010 - 10:48 | 512569 PlausibleDenial
PlausibleDenial's picture

KevinH, thank you for your explanation.  I have the same feeling that most of the ZH'rs have in terms of our dilemna, however, I come to this site for educational purposes and, at times, humor from some of the sickest minds I have read in years.  While I do understand the yield curve I did not understand the lexicon if you will.  Thanks again!! I have a feeling that "us" newbies could benefit more by the help of those that have been entrenched in this market.

Tue, 08/10/2010 - 12:03 | 512751 kaiserhoff
kaiserhoff's picture

Good summary by Kevin.  One further point.  Bond firms, bond holders, mortgage dudes, pension plans, etc. are close to panic because they see themselves holding 3-4 percent paper in a 10-12 percent world.  Value of bonds and notes is the inverse of the interest rate.

As the yield curve flattens, there is no incentive to go long.  That destroys the market for existing cheap debt, and restores order to the known universe.  A flat yield curve means it's later than you think in the credit cycle.

Tue, 08/10/2010 - 10:24 | 512496 Tic tock
Tic tock's picture

Please take a moment to honour those who discovered popcorn

Tue, 08/10/2010 - 10:36 | 512525 lettuce
lettuce's picture

And those who invented microwave popcorn, which takes between 2-3 minutes to pop these days. I suggest everyone pops a bag at 2:10 and gets ready for the ride. Hors d'oeuvres are served.

Tue, 08/10/2010 - 10:33 | 512499 realtick
realtick's picture

Wake me up when the VIX breaks out.

http://i33.tinypic.com/2d1mqdl.jpg

 

 

 

Tue, 08/10/2010 - 10:48 | 512565 -1Delta
-1Delta's picture

It cant stay this low much longer. It can not expire this low, and the long gamma trade will work.

Tue, 08/10/2010 - 10:29 | 512506 Modus
Modus's picture

well i would say you need at least 10M to set up such a trade with your bank...

however, i wonder why swap spreads are at record wides when the spread on the 2s10s is as flat as it is now...

anyone a profound, academic explanation for it? really interessted in that

Tue, 08/10/2010 - 10:31 | 512513 gmak
gmak's picture

2s10s is Treasury spread ("risk free", heh). Swap spreads reflect credit risk --> AA theoretically, no?

Tue, 08/10/2010 - 10:41 | 512544 jm
jm's picture

swaps are saying ZIRP 4ever.

Tue, 08/10/2010 - 10:30 | 512512 firstdivision
firstdivision's picture

Baltic Dry seems to decoupled from reality.  It is up 4% today...wtf!?!

http://www.bloomberg.com/apps/quote?ticker=BDIY:IND

Tue, 08/10/2010 - 10:36 | 512532 lettuce
lettuce's picture

capesize boats loaded up with ipad shipments from china

Tue, 08/10/2010 - 11:06 | 512607 Grand Supercycle
Grand Supercycle's picture

SP500 important chart update :

http://stockmarket618.wordpress.com

Tue, 08/10/2010 - 11:09 | 512613 Grand Supercycle
Grand Supercycle's picture

dupe

 

Tue, 08/10/2010 - 12:24 | 512795 kaiserhoff
kaiserhoff's picture

Are bonds boring?  Yes, but think about what happens to the balance sheets of banks, AIG, Fannie and Freddie, etc.  when even "good loans" are worth 20-30 cents on the dollar and have to be financed at short rates of 8 percent or more.  That is what brought on the S & L collapse of the 80s.  It is also another inevitable consequence of Ben and Timmy's wonderful adventure.  Happy Trails.

Tue, 08/10/2010 - 12:26 | 512801 Catullus
Catullus's picture

I'm sure the fed "reinvesting" in the long end of yield curve will make this a total non-issue. Wait, it makes it flatter? Uh.

Here's a good one. Fed swaps performing MBS at high yields with low yielding treasuries.

Tue, 08/10/2010 - 13:05 | 512886 nit.noi.baht
nit.noi.baht's picture

What will that do to my Pimco 401k?

Tue, 08/10/2010 - 14:11 | 513016 johngaltfla
johngaltfla's picture

In 5 minutes that bitch is going to be flatter than Senator Robert Byrd's EKG.

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