By Kevin Muir
This afternoon some big shooter put on a monster U.S. steepening / German flattening bond trade. The specifics of the trade were;
- buy 100,174 US five-year treasury futures
- sell 63,887 US ten-year treasury futures
- sell 65,362 German bobl futures (5-year)
- buy 29,145 German bund futures (10-year)
I did get a few pings asking if I was busy writing some tickets, but alas, the ‘Tourist’s positions have a lot less digits. According to Bloomberg, this position has $4.7 million of DV01 risk (dollar-value per basis point). That’s way above my pay grade, but it’s worth thinking about the rationale behind this whale’s trade.
Let’s break the trade into two parts. The first is the US side. The trader bought the five-year US treasury future and sold the ten-year US treasury future. This half of the trade will profit if the U.S. treasury yield curve steepens between the 5 and 10 year portion of the curve.
The trade was executed at around 18 basis points. But where does this stack up compared to recent trading?
The curve has flattened like it’s Shrove Tuesday and we aren’t that far off the curve inverting. Let’s zoom out a little further and look at this spread through a couple of economic cycles.
During the past two economic cycles, the 5-10-year area of the Treasury curve went negative for at least a brief moment. Yet so far this cycle, the negative print has eluded us.
The trader executing this large bond trade is betting the U.S. 5-10-year spread will rise, but not in an absolute sense, only that it will gain more than the German 5-10-year spread.
Here is a chart of the German 5-10-year spread.
The German yield curve is much more positively sloped than the U.S. curve.
The trader’s position can therefore be summarized as a relative bet on the two countries’ 5-10-year yield curve spread.
Putting it all together, it’s designed to profit if the US 5-10 curve steepens more than the German 5-10 curve, or conversely if it flattens less. Either way, here is the chart of the difference between the two different curves.
I suspect the U.S. yield curve is too flat, so I am partial to the American part of the trade. There is too much economic optimism built into the short-end of the US curve. This confidence has allowed the Federal Reserve to hike rates more quickly than any other central bank ove the past couple of years, sending the 3-month LIBOR from 0.25% to 2.36%.
The risks are that the economic cycle is getting long-in-the-tooth and that in coming months, U.S. economic numbers disappoint elevated expectations. In that scenario, I expect the 5-10-year spread to widen.
As for Europe, who knows what’s going on with their crazy monetary policy. Will they stick with negative rates forever? Or will Mario Draghi’s stepping down at the end of his term allow a German to be put at the helm of the ECB and raise short rates back to zero?
I don’t know, but a hawkish ECB will most likely cause the same sort of flattening the U.S. has experienced over the past couple of years. When examining the age of the two countries’ economic cycles, Europe is a few years behind the U.S., so a flattening German curve very well might be the right call.
Yet I am not sure if it is worth the hassle playing the yield curve differentials. The US steepener is a great risk-reward trade and it might make more sense to separate the two trades. Owning the U.S. 5-10-year steepener and then shorting the U.S./German 10-year spread might be a better way to organize the trade.
After all, the spread between U.S. and German 10-year bonds hasn’t been this wide since the fall of the Berlin wall.
Maybe this Shooter McGavin of a bond trader is being too cute for his/her own good. After all, never forget that Shooter blew a 4 stroke lead on the back nine.
Thanks for reading,
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