Visualizing The Past Of The Treasury Yield Curve, And Deconstructing The Great Confusion Surrounding Its Future
The chart below shows the UST yield curve over the past 20 years: as is more than obvious, every single point left of the 10 Year is at record tights. The only question on everyone's lips is where do we go from here. And that is where the confusion really hits.
The confusion is further intensified by the sudden collapse in the 2s10s and the 2s10s30s butterfly. The odd thing here is that a flattening move as violent as recently seen in these two curves, has historically preceded a rise in the Federal Funds rate as can be seen in the chart to the right, before the Fed began tightening in 1999 and in 2004. In other words a flattening has traditionally been a leading indicator to an economic improvement (as liquidity extraction tends to go side by side with a pick up in inflation and thus economic growth). Alas, this time around, a tight monetary policy is the last thing on the Fed's mind, and the economy is only starting to demonstrate it is rolling over into a second and more violent recessionary round. In essence, the Fed's interventionist intention of purchasing the entire curve (including the long-end), as recently announced by the FRBNY, has completely dislocated all leading signaling by the curve itself. As a result, speculation is now rampant as to what may or may not happen. A case in point are the divergent opinions of Bank of America and Morgan Stanley. While the former Merrill Lynch is advocating an outright 10s30s flattener, Morgan Stanley is sticking to its guns and continues to push for a steeper curve: this in spite of the collapse in the 2s10s from a records steepeness of almost 290 bps in May, to under 220 bps as of Friday's close: the over 25% collapse is enough to blow up most of the funds who had positioned themselves for further steepness. At least Morgan Stanley is consistent. Yet both banks urge clients to hedge their trades and provide creative ways to do so, as both realize the likelihood of being wrong, now that the Fed is openly the biggest market participant, is probably higher than the inverse.
Of course, it is now obvious what the Fed wants to achieve, as it gets ever close to using the last available nuclear option: outright monetization of every single asset class. The graphic representation of what Bernanke would like more than anything to be the economic reality is presented on the chart below.
We hope that when looking back in 2012 at this post we are proven wrong, as a completely flat yield curve coupled with an economy that is collapsing ever faster, is the surest way to an outright stock market supernova, that will take obliterate all asset levels in a bout of hyperdeflation (for leveraged items), followed by hyperinflation (for items purchasable by banks with discount window access).
But back to the confusion. First, we present BofA's investment recommendation for 10s30s flattening. To BofA's credit, the recommendation which came out on the 11th before the FRBNY's surprise announcement it would also purchase 30 Years, despite previous indications it would only focus in the 2-10 Year belly of the curve, did anticipate that the Fed would go hog wild in buying the very end of the curve as well.
10s-30s Treasury Curve flattener; long 2m30y Receiver
We recommend two trades to position for an outperformance of the long end of the Treasury curve – 1) 10s-30s curve flattener and 2) long 2m30y ATM receiver
Our main rationale for the outperformance of the long end is an asymmetric response to Fed buying of Treasuries in the 10year+ sector. We believe that the market has significantly underpriced the likelihood of Fed buying of longer dated Treasuries. As Figure 9 highlights, most of the decline in rates has been led by the 10year. Thus we believe that a 10s-30s flattener position offers a 3 to 1 payoff ratio. The market is not looking for the Fed to purchase securities in the 30yr sector, but we think that this is a misinterpretation of the NY Fed operational statement. In 2009, even though the Fed concentrated purchases in the 2-10 year sector, it bought about 15% in the long end.
If the Fed does buy 30s, which occurred in the first week of purchases after the Fed announced the program in March 2009, we believe that the long end will outperform significantly, flattening 10s-30s. If the Fed does not buy the long end in the near term, we believe that the curve will not steepen on disappointment since the curve has not flattened on the back of the announcement yesterday.
We like putting on the trade today right before the Fed is expected to announce the schedule of purchases for the next month. Further, we believe that position unwinds in 10y-30y flatteners have pushed the curve to unprecedented levels (Figure 8).
One risk to an outright 10s30s flattener trade is that the curve may steepen sharply due to any further capitulation of flatteners. Thus, we also suggest a
2m30y receiver position. We expect the 30-year treasury rate to decline in case the Fed announces purchases in the 30y sector, which should also result in the decline of the 30y swap rate. This trade is protected from a further steepening of the curve by the size of the receiver premium.
Flattener: We recommend shorting the 3.125% of 5/19s versus owning the onthe- run 30 year. The 5/19s is cheap to borrow in the repo market and the SOMA holds 7% of this issue. Further the 2018-19 sector is rich on our spline. The on the run 30year is marginally rich on the curve, but we own that sector for liquidity premium and the Fed barely owns this issue in the SOMA. Specifically, we recommend buying $44mn of the on-the run 30 year Treasury and selling $100mn of the 3.125% of the 5/19s at a spread of 144bp
Receiver: We buy $5mn notional of ATM 2m30y receivers at 260bp per notional. The break-even rate for this trade is 14bp below the forward rate.
The biggest risk to this trade is positioning led. Since 10s-30s has been steepening for the last few months, the flattener trade has been crowded. However the aggressive flattening over the last week suggests some capitulation on these positions. Thus positioning might be a little cleaner today.
Yet no investment recommendation on rates can be complete without the opinion of Morgan Stanley: the firm which has been calling for dramatic steepening on the heels of a second American golden age. Over the past year, MS' Jim Caron has expected that courtesy of the Fed's prior actions, the US economy would skyrocket, and the result would be a curve steeper than ever. While Caron was correct through May (for all the wrong reasons as it now turns out; his call for 5.5% in the 10 Year at year end is now dead and buried), the past 4 months have shown just how horribly wrong a thesis that appeared correct on the surface may be, when the actual drivers are completely disproven to have been in any way relevant. Yet despite the increasing bear flattening of the curve, Caron continues to push the steepener trade (presumably not to those who have lost a unlevered 25% from the 2s10s' peak some months ago). And with the Fed now the purchaser of first and last resort of every point in the curve, it is obvious that the flattener is the Fed frontrunning trade. Which in itself is a paradox, as further flatness will increasingly slow down the economy and reduce profit margins for banks and mortgage originators (not to mention once again bring about a spike in NPL levels).
Regardless, for a combination of a weak mea culpa from Caron, together with an intransigent and resolute decision to stick with the "Steepener or Bust" theory, here is Jim Caron's thesis (as well as the natural hedge, in the off chance that just like before, Jim is completely wrong on both the shape of the curve and the shift in the economy), which he now affectionately (and falsely) calls the Fed's "New Regime."
A regime change is underway for the Fed. It is that they are becoming reactive instead of proactive in their use of tools to stimulate the economy. Repeatedly they have mentioned their policies will be data dependent. Supporting this thesis was the announcement from the Fed to purchase USTs. We think it was premature and reactive to weak data from May and June and ignores the strengthening in equities and positive sentiment that goes along with it. The consequence is higher term premiums. Not only do Fed actions ignore the possibility for data to improve in Q3, they also foster a risk of debt monetization. Thus, we argue that although the UST 2s10s curve may flatten, it will remain steeper than ordinary – the steepening of the forward curve supports this view and risk for further record-breaking steepening of the UST 10s30s curve persists.
What's in the price. The market is priced for a slow move to higher Fed Funds rates. Based on the Fed Funds futures market, the Fed is priced to hike only once by the end of 4Q11 to a level of 50bps. Where we differ is that we believe the Fed Funds rate will be at 1.0% at that time (Exhibit 1). This is not in the price. As one can see, a 1.0% call for the Fed Funds rate by the end of 4Q11 is pushing the envelope of a market implied confidence levels as derived by the Fed Funds options market.
Regime change. A key take-away about our rate call, which should not be lost on anyone, is that we expect the yield curve to remain near its cyclically steep levels despite our expectations for the Fed to hike rates in late 4Q11. This is more than just nuance. It is the source of why our forecast for UST 10y yields tends to be higher than consensus (Exhibit 2).
The reason is that we argue that the Fed is taking a reactive stance instead of proactive in terms of inflation risks. The result is that inflation risk premiums, and subsequently term premiums on the yield curve, will be higher going forward. Said differently, the curve is likely to remain stubbornly steeper for longer even in the face of lower inflation. This is the regime change we are referring to.
Record breaking curve steepness. The record breaking steepness of the UST 10s30s curve supports our thesis for a regime change toward steeper curves. Investors have turned toward buying the belly of the UST curve, the 5yr and 10yr sectors, in an attempt to buy yield as they expect the Fed to be on hold for an extended period. This will only be accentuated with the Fed’s recently announced plan to purchase USTs. But there are limits to this strategy and it seems to end at the 10y point on the curve. Beyond the UST 10y point we note that the term premium continues to rise, as measured by the all-time steep levels of the UST 10s30s curve, and the same is true for the UST 5s30s curve. Both curves highlight the relative richness of the belly to the 30y point (Exhibit 3).
But that’s not the whole story. Even the 2-yr forward 2s10s curve forward curve is steepening. It’s near the peak set back in 1992 despite the fact that the spot curve is flattening. Usually major turning points for spot and forward curves are in sync within weeks of each other. However, today the spot curve is out of sync as it peaked 6 months ago while the forward curve keeps steepening (Exhibit 4). This reluctance of the forward curve to flatten supports our view for higher term premiums as Fed policy is more reactive and risks of debt monetization.
Diminishing returns to investing in longer maturities. Investors see diminishing returns to investing in longer maturities because inflation risk premiums are higher. This defines why we think the curve will remain steeper for longer despite the fact that core CPI will likely be lower than average. The irony is inflation risk premiums will be higher despite lower absolute levels of inflation because the Fed is at risk of falling behind the inflation curve. This is the critical linkage we want you to make because it explains why our call for back-end rates tends to be higher than consensus. Simply, it's why our call is differentiated.
While this is all great in theory, those who wish to bet that Caron will be as wrong now as he has been in the past, are advised to read that below section very carefully.
The Risk Case: Slower Growth and a Deflation Scare
The short-term dynamics may trump the long-term. Economic data over the next 4-6 weeks are critical because if they show softening, then it will be unlikely that we get above 3% growth in 3Q, and for that matter in 2H10. 3% 2H10 growth plus 1% inflation is at the core of our assumptions for 10y yields to rise to 3.5% by year-end. If this does not develop, then the risk is we get 2% growth; a threshold for a deflation scare as we see it. This is the risk scenario that could bring the UST 10y down to 2.00% - 2.25% and the UST 2y to 0.25%, flattening the spot UST 2s10s curve substantially.
In other words, everyone has an opinion, but more importantly, everyone is now fully aware that that opinion is very likely patently incorrect, and driven exclusively by one's position as a sell-side pitchman for a bullish economy, which has at its core the requirement to keep the ponzi going and to extract capital from clients on the sidelines, as they shift from realist to kool-aid optimist.
The bottom line is now that the Fed is once again actively involved in controlling the curve, and thus risky assets, the result is utter confusion. If two of the biggest investment banks can not agree on something as simple as the shape of the yield curve, how is it that they or anyone else, can have an informed opinion on where assets that return more than 4% (in 30 years) will head in the future. Essentially, uninformed coin flipping is now the best paid occupation in the world.