By Kevin Muir
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.
Thanks for reading,