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.