Pain Trade Is For A Steeper Yield Curve

This bear steepening is the maximum pain trade. 

That's the ominous first line from a quick note to clients from Goldman's Anshul Sehgal, co-head of US Interest Rate Products Trading, and Muhammad Qubbaj, head of North America Interest Rate Product Sales and co-head of Cross Assets Sales, release this morning on the drivers of the current rates moves.

It's a trade that hurts real money both from a curve and level perspective.

The rates macro Hedge Fund community didn't have it on as it's still reeling from the March VaR shock.

It hurts anyone who had a conditional view, that is anyone in the bull steepening camp.

In 2022, we also saw a lot of banks move their mortgages into Held-to-Maturity portfolio as the Fed started hiking.

These moves will amplify the losses already accumulated.

Finally when you look at more recent MBS vintages, the negative convexity will be painful here. (Side note: older vintages have actually turned positive convexity so those MBSs should be much better off). 

The only cohorts that seem to have the right trade are cross over accounts that hedged against higher rates and CTAs - trend following Hedge Funds - that were picking the carry by shorting the frontend and selling the backend. 

2s30s is back at its least inverted since May...

As Bloomberg's macro strategist Simon White, detailed earlier, Friday’s jobs data sparked a relief rally in bonds and a flatter yield curve, but the pain trade is still for higher yields and a steeper curve – the lesser-spotted bear steepener – with this week’s CPI a potential catalyst.

Last week was a turbulent one for bonds, but the continued softening in payrolls data served to remind the market that supply and fiscal-profligacy fears have to be counter-balanced with an economy that’s in its late-cycle stages.

After the data, 10-year yields took the elevator back down to sub-4.05% after briefly going above 4.20%. They have since clambered back to 4.12%, but their next cue is likely to come from Thursday’s CPI report. Headline is expected to nudge back up to 3.3% (from 3% last month), mainly due to base effects, and core is expected to hold steady at 4.8%.

Still, stronger-than-expected data probably means higher yields in a market more acutely alert to inflation (and therefore supply) risks. As with last week, term premium would likely drive the move, meaning a curve steepening. After relentlessly flattening for the last two years, the pain trade is for a steeper curve. Implicit positioning of speculators from the COT report shows there is a heavy skew to a flatter curve.

The negative carry for most steepeners remains punitive (for 2s10s USTs it’s ~83bps over a year), but the large upside potential from supply/inflation worries and the covering of positions begins to make that look less insurmountable.

Finally, the Bundesbank’s decision to stop paying interest on domestic government deposits - which initially pushed short-term German bonds higher this morning - highlights the broader issue of central banks paying interest on reserves when they are superabundant.

In the days of QE and 0% interest rates, the ECB and Fed at al. remitted money to their treasuries from the income on their bond portfolios.

But now that is reversed as bond income is dwarfed by the cost of paying interest on trillions of bank reserves. Take the Fed, whose debt to the Treasury is now accruing at over $2 billion each week.

This is something that will become more politically contentious, especially as economies continue to slow and cost-of-living pressures bite further.