Via Kevin Muir of “The Macro Tourist” fame
Just one more post about yield curves – I promise! With Friday’s release of the CFTC commitment of traders report, I couldn’t resist.
In the coming years, I believe the yield curve steepener has the potential to be one of the all-time great trades. Eventually, I think the Fed, along with all the other developed countries’ Central Banks, will lose control of the long end, and yield curves throughout the world will explode to record wides.
As I discussed previously, I am not sure about the long-term timing. Will the Fed invert the curve? Or does the new post-GFC environment throw all those old playbooks out the window?
I am still trying to decide about my long-term positioning, but I am increasingly confident, from a short-term trading perspective, the 5-30 steepener trade is a screaming buy.
Why do I feel so strongly?
Let’s start with the speculative positioning within the US Treasury futures complex.
Speculators are now record short five-year treasury note futures!
But the really interesting part?
They are long 30-year bond futures.
And they are even long the 10-year note futures.
So it’s obvious the spec community has the 5-30 year flattener (or 5-10) on in size.
Easy to see why. It’s been a one-way ticket.
I don’t know if this is the ultimate bottom in the 5-30 year spread, but at least for a trade, it’s a great bet down here.
Anytime the hedge fund crowd of wise guys become this sure of any trade, it’s time to write a ticket fading them. Remember, the new reality is that the market is nothing more than a Series of Rolling Mini-Bubbles. Flattener trades are by no means immune to this phenomenon.
And the real kicker? The steepener is a positive carry trade. The always enlightening hedge fund manager Mark Dow recently had a great exchange on twitter about the carry on the 5-30 steepener trade (click here if you want to be taken to the twitter thread).
Now there is some debate about measuring the carry on a steepener trade. Basically, it comes down to the fact that to get the position balanced so that one basis point change in 5-year yield equals the same as one basis point change in the 30-year yield, you need to be long many more 5-year futures.
Here is the hedging ratio to get the position balanced.
So you need 4 times as many 5-year note futures. Even though the 5-year note cheapest-to-deliver (the “CTD” that Mark referenced) yields 1.95%, which is less than the 2.577% equivalent for the 30-year future, the fact that you are long so many more five-year futures (which are yielding more than the short-term overnight rate), means you pick up more carry than you pay out.
I know – boring bond stuff. I get it.
The important part to realize is that if you slap this position on and nothing happens, not only do you not lose, but in fact, you pick up the carry that Mark references.
During Mark’s twitter discussion, one of the more astute readers, Joseph S. Mauro, noted that “you’re a Taylor heading away from losing a year of carry in 15 minutes…”
And that’s the worry. A hawkish Federal Reserve Chairman appointment will flatten the curve quicker than the VIX’s recent collapse.
But isn’t that why the curve is so flat? This hawkish Fed Chair risk is at least partly baked in, and provides us with the opportunity.
Yet, more importantly, I am a seller that Trump puts a hawk in charge of the Federal Reserve. Say what you want about the guy, but if Trump has an area of expertise, it’s cheap credit. To think he will follow through with his campaign promise to return the Federal Reserve to an era of discipline is naive. He is tweeting everyday about the record high stock market. Do you think he wants that to end with prudent monetary policy? Not a bloody chance.
Enthusiasm about the stock market is running red hot. It’s due to roll over, and when it does, the curve will steepen. Not only that, but specs are leaning way too short the curve (they have flatteners on), and if there is one thing I have learned from these past few years, the one remaining trade that still works, is fading extremes in speculative positioning. Combine all this with a positive carry trade, well, ‘nuff said. Sign me up. I am buying the steepener for a trade.
Agreed he is likely to make the dovish final call – maybe even re-appointing mom – the trick will be to listen for his fake-outs to get the market off-sides – which it pretty much is – in the meantime to set up his front running fun.
Yeah dovish. But my concern about the steepener trade is, what prevents Powell and the other new doves that trump will appoint from buying long bonds via QE4 to thwart higher long yields and ruin the trade? Inflation expectations? Unlikely, because gov’t can/will lie about real inflation and do QE anyway. So for this trade to work, I think the government must lose control of things. In which case, bitcoin and real assets will do better as everyone finally sees fiat for the sham that it is and flees it. Readers here “get it” but the broad public doesn’t, so we’re not even close to that time yet.
And here you have it… Yellen’s speech this wkend on ‘Monetary Policy Since the Financial Crisis’:
“The probability that interest rates may need to be reduced to their effective lower bound at some point is uncomfortably high, even in the absence of a major financial and economic crisis. The bottom line is that we must recognize that our unconventional tools might have to be used again. If we are indeed living in a low-neutral rate world, a significantly less severe economic downturn than the Great recession might be sufficient to drive interest rates back to their lower bound.”
No removing the QE punch bowl or allowing yields to find their market price. PARTY ON!…lol
So BTFD.
So if we exclude the “I want a new great depression now” Taylor, who would be the only one to try to let the markets decide by how much the fall in assets (bonds) would be, we only get the “I will put the entire financial system on the Fed balance sheet if I have to” cabal, good times…
Just one more thing, capitalism without somewhat free financial markets, still capitalism?