Trump Presidency Ignites Bond Yields on Inflation ExpectationsThe “Make America Great Again” ethos has set the greenback on fire. Donald Trump's re-election has the US dollar surging 2%, extending its rally since early October to a total gain of 5%.
This resurgence is despite the anticipated 25 basis points (“bps”) rate cut at the November FOMC meeting. Dollar rally is driven by expectations of potential policy changes by the Trump Presidency.
HIGHER INFLATION EXPECTATIONS UNDER TRUMP 2.0
Trump’s election victory, combined with the Republican sweep of the Senate and the House of Representatives, gives the party the leverage to enact swift and substantial legislative changes.
His policies, such as corporate-friendly tax cuts & light-touch regulations, are expected to amplify corporate growth. These policies, combined with import tariff imposition, are expected to drive inflation higher. Rising inflation will curtail the pace of rate cuts by the Fed.
Rate cut expectations have eased since election. On November 6 (election day), projections pointed to rates reaching 350-375 bps on election day (6/Nov) per CME FedWatch tool. Now, they are expected to reach 375-400 bps.
Trump has previously pushed the Fed towards accommodative rate environment. Fed Chair Powell re-iterated that the Fed remains independent and data driven.
Source: CME FedWatch
Trump's proposed tariff policy will further strengthen the dollar. In August 2023, Trump announced plans for a universal 10% tariff on all U.S. imports, reiterating that tariffs on Chinese goods could be even higher, potentially reaching 60%-100%.
Such tariffs are expected to drive inflation higher. It will raise consumer prices and provoke retaliatory actions from trading partners, worsening inflation. Trump aims for these tariffs to revitalize American manufacturing and reduce reliance on imports which collectively support a stronger dollar.
STRONGER DOLLAR TRIGGER BOND YIELD SURGE
The resurgent dollar has contributed to the sharp rally in bond yields. The yield rally since October has resulted in the 10Y yield rising by 60 bps. Yields initially surged after the election result but partially reversed the following day after the FOMC meeting.
It currently stands 5 bps higher than the pre-election level.
Unlike the yield, the yield spread has remained flat since October. Higher for longer rates act to push this spread lower.
The Federal Reserve reaffirmed (at its Nov meeting) its dovish tone as Powell pointed to signs of an easing job market and slowing inflation. However, its impact on curbing bond yields was limited.
According to a JP Morgan report , while Fed Chair Powell has consistently conveyed a dovish tone over the years, the Fed's actual decisions have often skewed hawkish.
Although Powell’s dovish statements have initially brought bond yields down, the hawkish policy actions and Fed’s wait and watch approach that followed have typically led to renewed yield increases. This explains why yields continue to rise despite Powell’s dovish remarks at the November meeting.
HYPOTHETICAL TRADE SETUP
Treasury bond yields have been on the rise since October and Trump’s win has supercharged the rally. Investors are expecting higher inflation due to Republican policies which favour corporate growth.
Import tariff, if enacted, would have an even larger impact on the dollar and bond yields. However, actual policy plans remain uncertain for now.
While yields initially surged after the elections, they partially reversed shortly after as the Fed signalled a dovish stance. Despite this, the 10Y-2Y yield spread has remained unchanged.
Resurgent inflation will lead to the Fed slowing the pace of rate cuts. The recent reversal in yield spreads may be unsustainable given the expectation for slower rate cuts. When Trump administration announces policy plans, yields could surge even more strongly.
This week’s CPI release is anticipated to influence bond market movements. Analysts expect October’s YoY inflation to remain steady at 2.4%. If inflation holds at this level, it may have minimal impact, aligning with the Fed’s "watch and wait" strategy. However, a sharper-than-expected drop in inflation could reinforce expectations of quicker Fed rate cuts.
With the impact of inflation most apparent on the longer-tenor yields, investors can focus the position on the 10Y-2Y spread.
CME Yield Futures are quoted directly in yield with a 1 basis-point change representing USD 10 in one lot of Yield Future contract. This simplifies spread calculations with a 1 bps change in spread representing profit & loss of USD 10.
The individual margin requirements for 2Y and 10Y Yield futures are USD 330 and USD 320, respectively. However, with CME Group’s 50% margin offset for the spread, the required margin drops to USD 325 as of 12/Nov, making this trade even more capital efficient.
A hypothetical long position on the CME 10Y yield futures and a short position on the 2Y yield futures offers a reward to risk ratio of 1.3x is described below.
Entry: 6.2 basis points
Target: -11.5 basis points
Stop Loss: 20 basis points
Profit at Target: USD 177 ((6.2 - (-11.5)) x 10)
Loss at Stop: USD 138 ((6.2 - 20) x 10)
Reward to Risk: 1.3x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme .
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Treasuryyields
Yield Curve Reinverts on Easing Rate Cut ExpectationsFed sets the rates. Rates guide treasury yields. Fed remains data dependent. Incoming data creates nuanced shifts in yield spreads.
The September jobs report revealed 254,000 jobs added, significantly exceeding expectations of 147,000, with August figures also revised upward. This strong report, along with the JOLTS data from earlier in the week, indicates that the job market remains strong and not as weak as previously anticipated.
Despite the strong jobs data, the yield curve has inverted once again. While Mint Finance has previously highlighted that recession risks can lead to the yield curve inverting, that is not the only reason. This time around, the inversion is being driven by delay in rate cut expectations. CME’s Yield Futures enables investors to deftly express their views on the path of rates ahead.
JOB MARKET SHOWS MIXED SIGNS OF RECOVERY
The latest JOLTS figures showed U.S. job openings rising from 7.711 million to 8.090 million in August, with the previous month's numbers revised up by 38,000. Although job openings remain near a two-year low, the increase is a positive sign.
Rise in job openings was primarily due to increase in construction jobs (+138k), which are often seasonal, and government jobs (+103k). However, the overall report paints a mixed picture. Hiring fell by 99k from the previous month, and while total separations dropped by 317,000, the largest contributor was a 159,000 contraction in quits.
With fewer hires and a large drop in quits, the data suggests the job market is not particularly strong, as workers hesitate to leave their current positions with fewer being hired into new roles.
The Non-Farm Payrolls (NFP) showed 254,000 jobs added in September, with health care, social assistance, and leisure and hospitality sectors leading the gains. As a result of these additions, the unemployment rate eased to 4.1%. Hourly earnings grew by 4% YoY, with the previous month's figures revised upward to 3.9%.
RATE CUT EXPECTATIONS TEMPER
Further rate cuts are still expected, but the anticipated pace has slowed. Before the PCE inflation report on September 27, CME FedWatch indicated a cumulative 75 basis point reduction over the next two FOMC meetings in November and December.
Source: CME FedWatch
CME FedWatch tool also indicated a high probability of 100 basis-point cuts last month. However, after the encouraging PCE report, which showed inflation easing to 2.2%—its lowest level since 2021 and close to the Fed's target—the probability of a cumulative 50 basis-point cut has steadily risen.
Following the jobs report last week, the probability of cumulative 50 basis-points cuts surged to 80%.
The trend suggests that market participants are increasingly expecting a soft landing, with inflation easing and the job market remaining strong. A soft landing reduces the urgency for aggressive rate cuts, giving the Fed more flexibility to monitor the effects of previous rate hikes and lower rates more gradually.
Source: CME FedWatch
Crucially, Fed Chair Jerome Powell has suggested a similar outlook for rate trajectory. While speaking at the National Association for Business Economics, he suggested that if the economy continues on its current trajectory, he expects two more smaller rate cuts this year, or cumulative rate cuts of 50 basis points at the next two meetings. FOMC projections also signalled a similar rate outlook for 2024 as signalled by the dot plot below.
Source: FOMC
YIELD CURVE RE-INVERTS
Bond yields have increased sharply to their highest level since August on tempered rate cut expectations.
Crucially, the increase has been much sharper for the 2-year yields indicating near-term expectations of elevated rates for longer.
The result has been a re-inversion in the yield spread with 2-year & 10-year treasury yields now on par. Notably, the yield futures spread has declined more sharply than the treasury yield spread.
HYPOTHETICAL TRADE SETUP
Recent economic data points to rising likelihood of a soft landing. Expectations of rapid rate cuts have tempered accordingly. While rates are expected to continue declining, the pace is expected to slow with a cumulative 50 basis points (“bps”) of further cuts in 2024 likely.
As rates remain elevated for an extended period, the yield curve has begun to invert again. With current inflation easing, the inflation premium on long-term treasuries has diminished.
FOMC projections suggest a gradual path toward rate normalization, suggesting a potential near-term yield curve inversion before it eventually normalizes. Investors can express views on this outlook through CME yield futures.
Further, the yield futures spread is trading at a (~5bps) premium to the treasury yield spread, as the futures contracts approaches expiry on October 31, the futures spread will converge towards the treasury yield spread which further benefits the short position.
CME Yield Futures are quoted directly in yield with a 1 basis point (“bp”) change representing USD 10 in one lot of Yield Future contract. This simplifies spread calculations with a 1 bp change in spread representing profit & loss of USD 10. The individual margin requirements for 2Y and 10Y Yield futures are USD 330 and USD 320, respectively. However, with CME’s 50% margin offset for the spread, the required margin drops to USD 325 as of October 8, making this trade even more compelling.
A hypothetical trade setup comprising of long 2Y yield October futures and short 10Y yield October futures with reward to risk ratio of 1.5x is described below.
Entry: 13.5 bps
Target: -1.5 bps
Stop Loss: 23.5 bps
Profit at Target: USD 150 (15 bps x 10)
Loss at Stop: USD 100 (10 bps x 10)
Reward/Risk: 1.5x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme .
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Long 10Y, Short 2Y on Yield Curve NormalisationWorld's most important and the largest financial market is the US Treasury. Annual issuance of U.S. Treasuries has exploded. A record USD 23 trillion of treasuries were issued in 2023.
This market is experiencing gradual but notable shifts due to the Federal Reserve (Fed) recent tapering of quantitative tightening and the Treasury buyback. Collective impact has led to demand divergence across different maturities.
The yield curve starting to normalize once more. Economic outlook impacts the yield curve. Not only that, the Fed’s quantitative tightening (“QT”) campaign also has an enormous influence.
At its most recent FOMC meeting, Chair Jerome Powell stated that the Fed would start to slow its balance sheet runoff. The runoff results in supply contraction enabling greater demand for long-term treasuries and a subsequent yield curve normalization.
Runoff refers to the reduction in Fed’s balance sheet as they opt to let their treasury holdings mature without renewing them. This activity leads to a supply contraction.
RECENT HAWKISH FED MEETING CAME WITH A CAVEAT
Since 2022, the Fed has been engaged in a QT campaign. Raising rates is its primary tool. Balance Sheet reduction is an additional strategy to manage monetary environment.
The Fed first announced that it would start to reduce holdings of US treasuries at a fixed pace at its May 2022 meeting. The pace of reduction accelerated as Fed stepped up QT. Treasury runoff has continued at a fixed pace since then.
At the April FOMC meeting, Fed announced its decision to slowdown the runoff. In other words, Fed would start to let treasuries to mature at a slower pace.
Starting from the first of June, the Fed will decrease the maximum amount of treasuries that can mature without being replaced from USD 60 billion per month to USD 25 billion.
Fed’s outlook on rate cuts was hawkish. But its resolve to taper runoff is dovish signalling the Fed’s end of QT campaign through balance sheet reduction. Treasury runoff tapering impact will be noticed additional liquidity before rate cuts arrive.
HOLDINGS & RUN-OFF IS AIMED AT LONG-TERM TREASURIES
Fed’s QT via treasury holdings is implemented through the non-renewal of existing holdings.
Crucially, the impact of letting treasuries mature is more pronounced on long-term treasuries than short term ones. As short-term treasuries mature more often, the impact of this run-off on near-term treasury demand is limited.
In contrast, the impact on long-dated expiries is more pronounced. Analysing the cumulative run-off since May 2022, the largest impact on long-term treasuries has been on 5 to 10 years category which consists primarily of 10-Year notes. This run-off has been particularly high over the last few months. On the contrary, the holdings of 10+ year treasuries have increased.
Source – Federal Reserve
TAPERING RUNOFF SUGGESTS IMPROVEMENT IN LONG-TERM TREASURY DEMAND
Impact on benchmark 10-Year treasuries will be most pronounced as the Fed moves to slow the pace of its runoff. Longer maturities have lagged near-term ones at recent auctions. It was most apparent at the latest auctions.
The 10-Year treasury auction raised USD 42B, that is far higher than the average over the last twelve auctions at USD 31B. While the bid-to-cover was higher than the previous auction in April, it was below the average over the last twelve auctions. Indirect bidding was below average at 65.5%. Overall, this suggests an unimpressive result.
In sharp contrast, 3-Year treasury auction showed strong demand. It raised USD 58B, the highest since 2021. Bid-to-cover was higher than the last auction. Non-dealer bidding was also above average at 85.1% (81.7% average). Similarly, the Treasury 5-Year auction raised USD 70B with an above average non-dealer bidding. Both 3-Year and 5-Year auction results were much stronger.
As observed through the CME TreasuryWatch Tool , the demand for 2-year treasuries has been noticeably higher, as suggested by the bid-to-cover ratios, compared to 10-year and 30-year treasuries.
Source – CME TreasuryWatch
FED’S TAPERING TO FUEL 10Y SPREAD TO OUTPERFORM 5Y SPREAD
Yield curve is normalizing once more following the decline in the 10Y-2Y spread at the start of 2024. This trend is likely to continue as yields for longer dated maturities rise higher than near-term maturities.
Mint Finance highlighted previously that the 5Y-2Y spread is likely to outperform the 10Y-2Y spread. However, as Fed starts to taper its balance sheet run-off, the impact is likely to be felt strongest at the 10Y maturity allowing demand for these treasuries to rise once more.
HYPOTHETICAL TRADE SETUP
Fed’s balance sheet runoff slowdown and the underperformance of the 10Y-2Y spread relative to the 5Y-2Y spread, the 10Y-2Y spread has potential outperform in the near term as the yield curve turns to normalcy.
To harness gains from this normalization, investors can opt to execute a spread trade consisting of Yield futures.
CME Yield futures are quoted directly in yield with a one basis point change in the yield representing a P&L of USD 10. As yield futures across various maturities represent the same notional, spread P&L calculations are equally intuitive with a one basis point change in the spread between two separate maturities also adding up to a P&L of USD 10.
• Entry: -32.3 basis points
• Target: -28.3 basis points
• Stop Loss: -35.3 basis points
• Profit at Target: USD 400
• Loss at Stop: USD 300
• Reward to Risk: 1.3x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
What Next For The Inverted Yield Curve?Markets are notorious for exaggerated expectations. They sense a tiger when all they see is a cat. Expectations on rate cuts have been no different. Despite the Fed’s speak on measured changes to policy rates, markets got ahead of themselves since late last year. Markets are now starting to align their expectations with reality.
US economic data from January stands in stark contrast to December readings. Nonfarm payrolls and CPI are higher than expectations. A resilient economy and rebound in inflation have pushed expectations of rate cuts to much later this year.
According to the CME Group FedWatch tool, the probability of a rate cut at the March FOMC policy meeting dropped from 73% on 29 Dec 2023 to merely 8.5% as of 19 Feb 2024. First rate cut is now expected at the 12 June policy meeting this year. Markets are now pricing four rate cuts instead of six cuts as previously anticipated.
Shift in rate cut expectations has led to a rebound in US treasury bond yields. This paper delves into the factors behind the shift in rate expectations. The paper also analyses a hypothetical trade setup using CME Group Yield futures that investors can deploy to harness gains from revised policy path ahead.
RATE CUT EXPECTATIONS IS BECOMING MORE ROOTED IN REALITY NOW
A stream of recent economic data from the US has pointed to a stronger economy and a rebound in inflation, causing rate cut expectations to shift.
January nonfarm payrolls report showed 353k jobs added, exceeding expectations of 333k and the largest build since January 2023. January CPI report showed annual CPI growth slow from its pace of 3.4% in December 2023 to 3.1% in Jan 2024 but still hotter than analyst expectations of 2.9%.
Core CPI was another concern as it stood unchanged at 3.9%. On a monthly basis, CPI jumped 0.3% MoM. 0.6% MoM increase in rent prices and 0.4% increase in food prices were behind the monthly increase.
On the positive front, PPI fell 0.1% MoM in January, with goods prices 0.4% lower. PPI is just 1% higher YoY against an estimate of +1.3% estimate.
January Retail Sales fell sharply by 0.8% MoM in January. December growth was revised lower from +0.6% to +0.4%. This is expected to lead to a lower GDP growth in Q1. GDPNow model from the Atlanta Fed predicts 2.9% growth in Q1, compared to 3.4% before the release.
As a result of the broadly stronger data and higher inflation, expectations of rate cuts at the 20/March FOMC meeting have fallen from their peak of 74% on 29 December 2023 to 8.5% as of 19 February 2024. Expectations for a rate cut by May have also been scaled back. As of 14 Feb 2024, there is just 35% probability of a rate cut at the 01 May FOMC meeting as well.
Source: CME Group FedWatch
FedWatch indicates 50% probability of a rate cut for the meeting on 12 June 2024, which is up from 40% a week ago.
Source: CME Group FedWatch
The increase reflects the recent retail sales and jobless claims data that was stronger than expected. Both have led to a pullback in bond yields from their 2024 highs.
Source: CME Group FedWatch
The CME Group FedWatch tool indicates expectations of four rate cuts in 2024 as of 18/Feb down from six cuts at the start of the year.
The expectations around rate cuts have also shifted in Fed’s messaging. Atlanta Fed President Raphael Bostic stated that the Federal reserve does not face any urgency in cutting rates due to the current strength in the US economy. Dallas Fed President, Lorie Logan, shares similar sentiments .
Fed Chair Powell echoed the same message. Powell stated the Fed won’t cut rates until it has greater confidence that inflation is moving sustainably to its target. Specifically, he mentioned that a rate cut was unlikely by March. In an interview with “60 Minutes”, Powell suggested that Fed’s base case scenario of 75 basis points of rate cuts in 2024 was unchanged.
As a result of delayed rate cuts expectations, US treasury yields have rebounded.
FOMC MINUTES TO REITERATE HAWKISH POSTURE
Strong economic data and inflation numbers coming in hotter than expected will keep the Fed hawkish in the near term. How long will be anybody's guess?
On 21/Feb (Wed), minutes of the FOMC January meeting will be published. Expectations are for Fed to reiterate its hawkish posture. In anticipation, the 2-year yield futures are up forty-nine basis points (bps) to close at 4.601% as of 16/Feb (compared to 4.112% close of markets on 1/Feb).
Meanwhile, during the same period, the 10-year yield futures jumped forty-five bps to close at 4.295% as of close of markets on 16/Feb.
Taking directional views on the 2-year or the 10-year yields can be difficult when rate expectations are already baked into the yields. Directional views expose the trade to large downside risks vastly reducing reward-to-risk ratio.
In sharp contrast, spread trades enables trades to lock in gains while minimizing downside risks. This paper illustrates a hypothetical treasury spread trade below.
HYPOTHETICAL 10Y-2Y TREASURY SPREAD TRADE
Portfolio managers can better harvest gains from rate moves by trading the closely monitored US Treasury yield spread measuring the gap between yields on 2-year & 10-year Treasury notes. FOMC minutes reiterating a hawkish posture will invert the yield curve even more.
To help traders monitor this spread, the CME Group publishes a Micro Treasury CurveWatch tool which shows daily, weekly, and monthly changes in yields and major yield spreads.
Source: Micro Treasury CurveWatch tool
Portfolio managers can express this view by taking a short position in the CME Group 10-Year Yield Futures (10YG4) and a long position in the CME Group 2-Year Yield Futures (2YYG4).
● Entry: -0.2790 (27.9 bps; enter the spread trade when 10YG4 minus 2YYG4 is -0.2790 bps)
● Target Exit: -0.3690 (36.9 bps)
● Stop Loss: -0.2250 (22.5 bps)
● Profit at Target: USD 90 (9 bps x USD 10)
● Loss at Stop: USD 54 (5.4 bps x USD 10)
● Reward to Risk: 1.66x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
BTC BULLISH BRAINSTORMHappy Spooky Season boys and girls! Here is just a mock up of how I have been navigating Bitcoin. I am currently short term bullish and possibly long term bullish due to the season and recent price action across major indexes, commodities, the dollar, and Treasury yields. However that is remain to be seen and I will adjust my theses when necessary.
Cool side note: If you had been dollar cost averaging every time BTC went oversold on the daily RSI over the last 12-18 months, you would have an average price per Bitcoin somewhere in the ballpark of $20,000.
As of today you would be up 37% on that strategy.
Dollar and Yield Favored Setup Leading to the FOMCThe Dollar and US treasury Yields are all showing signs of future strength leading to the FOMC meeting, as the EURUSD has slammed into Resistance with Bearish Divergence and PPO Confirmation, the Yields have hit a Shark PCZ with PPO Confirmation, and XAUUSD has once again hit the PCZ of a Bearish ABCD and will give us PPO Confirmation of a Type 2 Reversal once, and if it starts going down again.
US10Y: Excellent long term sell opportunity.The US10Y turned neutral on the 1D timeframe today (RSI = 51.795, MACD = 0.074, ADX = 33.857) after it got rejected on R1 two days ago. It is likely to see a sharp fall as on the March 2nd rejection, and in that case S1 and S2 won't pose any bullish pressure to the downtrend, nor should the 1D MA50 and 1D MA200, which in the past 12 months haven't had any such significance.
Consequently, we consider the current level early enough for a low risk sell position on the long term, targeting the S3 (TP = 3.300%). As you see, the trading structure follows quite similar legs since November and right now we are most likely on a leg 2.
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Bond Yield Inversion vs. SPXThis is nothing new, really. People who have been in markets long enough know that when short term bond yields (3 month and 2 year, for example) come up to meet and invert to a higher yield than longer term bonds (like the 10 year, 30 year etc) that it often precedes a large market sell off as well as a recession that affects most everyone, not just stock prices.
On this graph, I maybe got a little carried away. I have the 1 month, 3 month, 1 year, 2 year, 10 year and 30 year as well as the actual Fed Funds rate with SPX in the background.
This goes back to the mid 1990s, you can see the dotcom boom, you see the yields invert, SPX tops and then takes near 3 years to finally find bottom before reversing course.
Unfortunately for long only stock holders, the treasury yields started to climb with stocks as well until they inverted in 2007 once more. Stocks started to come down, and, well, then 2008 happened...
You can see that in general, the fed funds and the shorter term yields find a plateau at their top, tend to stay there for awhile (sometimes for a whole year), then as they start to come back down, the stock market tends to be near its highs, and then the stock market starts to come down.
Big money tends to see higher treasury yields as a safer haven for their money than stocks at this point. If you have the ability to hold the treasury to expiration, you're guaranteed to get 100% of the money back plus whatever the yield % was at time of purchase as interest paid to you by the government.
Furthermore, there is an inverse relationship between bond yield percentage going up, and the value of bonds on the open market. As yields go up, the value of bonds goes down. Vice versa, as yields start to retract, bond values go up. So, there is high incentive to start buying a lot of bonds as the rates plateau near the top. Maybe some of these large hedges start to sell some equities as a hedge and buy more bonds as we get to that point. Rebalance their portfolio to be more bond-heavy.
Higher short term yields, higher fed funds rate also generally mean that the cost to borrow money for anyone is higher. Higher interest rates means more money out of the pocket of anyone borrowing to pay interest. Bonds themselves are just government debt.
The stock market is generally forward looking, so it's often making moves in response to moves in the bond market before main street really starts to feel the effects of the tightening in a meaningful sense. As time has gone on, it seems the market is reacting earlier and earlier to rate hike cycles.
Take 2018 for example, the yields didn't really invert until they all were already on their way back down. 2018 had volmeggedon to deal with to start the year, then came back, set a new high, then had a very rough second half of the year as bond yields plateaued. But, as the market saw that this small rate hike cycle didn't do any meaningful harm to the economy and started retracting, stocks took off again:
Then COVID happened, yields plummet, cost to borrow was as cheap as it ever has been, the government pumped money everywhere to try and prevent a complete collapse of everything, stocks were off to the races harder than ever before after finding bottom just a few weeks into the pandemic.
But, mentioning the market kind-of getting ahead of itself again, we had all of 2022, as it became apparent that inflation was now raging and bigger rate hikes than we've seen since the Great Financial Crisis would be necessary, the stock market sold off despite the economy still showing very solid recovery out of the pandemic.
But now, treasury yields are still climbing, but so are stocks. Treasuries hit a little hiccup in March as a couple regional banks were found to be overlevered in treasuries that had too low of a yield, and as more people began withdrawing money and those banks needed liquidity, they had to sell those treasuries at a loss. If they didn't have to come up with that liquidity and were able to allow those treasuries to mature, they make that small percent of interest for holding them. But because they were forced to sell them as treasury values were at a low because they had inadequate liquidity to cover deposits being withdrawn.
But, now maybe surprisingly, despite some of the troubles and the market sell off for most of 2022, we're now not all that far off of CBOE:SPX 's highs from the end of 2021, start of 2022. But, we still don't know what the full effect of the current high interest rates are going to be. It's possible the old mechanism where when we finally reach the top for interest rates, right as we get the precipice of rates starting to fall, equities top out and start to sell off shortly thereafter again. For how big and how long? Who knows.
Despite the recent 'skip' from the federal reserve, opting to not hike at the June meeting, the 3 month yield, which typically is what most closely matches/leads what the fed is going to hike to, has in recent days made it look increasingly likely that we see at least a quarter point hike for July. The market probably won't like that news, maybe we get a few red days, but if economy data coming in still looks solid and inflation is showing a slow, steady reduction, it may not be long before the market decides to go back up again. We might even go past the 2021/early 2022 highs this year.
But, eventually, we'll find the top for yields, and I have a feeling a bigger correction for stocks will loom at that point. For right now, seems like a bad idea to go against the bulls. But, keep an eye out for when we finally reach the top in treasury yields, look in particular for the 3 month, fed funds and the 2 year to go sideways. Once all 3 start to go down, pay closer attention to economic data coming in. Also take a look at www.tradingview.com for evidence of lower highs off the lowest point for the current cycle. You see the combination of the two, we may be in for a big correction. Again.
The yield curve has to un-invert eventually… right? (Part 2)This week, we thought it will be interesting to review the trade from last week given the reaction post-FOMC, as well as discuss an alternative way to set up this trade.
Firstly, let’s review the post-FOMC/employment data reaction.
- Nonfarm Payrolls surprised to the upside, as over half a million jobs were added way above the estimates of a sub 200K number.
- Unemployment rate continues to fall further, reaching a 53-year low of 3.4%
A clear re-pricing has occurred since last Friday’s better-than-expected jobs data and Wednesday’s Federal Reserve meeting. With markets now expecting 1 more rate hike in May, bringing the peak rate up from the 475 -500 bps range to the 500-525 bps range.
Keeping this in mind, we go back to our analysis last week to understand this situation and historical precedence.
While the time for a pause in rate hike seems to be pushed back, in the grand scheme of things, we think that this has only kept the window of opportunity for this trade open for longer and at a more attractive entry point now.
Without repeating ourselves too much, we encourage readers to take a look at our idea last week which explores the historical correlation between the peaking of yield curve inversion and the pause in Fed rate hikes.
Link to our last week’s idea:
This week, let’s tap into a different instrument. Here, we aim to take a short position on the 2Y-10Y yield differential by creating a portfolio of Treasury futures to express this view.
To do so, we would have to first select the 2 instruments, the 2-Yr Treasury futures is a straightforward choice for the short end. But for the 10-Yr leg, we have a choice of the '10-Yr Treasury Note Futures' vs the 'Ultra 10-Yr Treasury Note Futures'. Digging into the contract specification, the 'Ultra 10-Yr Treasury Note Futures' provide a better proxy for the true 10-year duration exposure as the delivery requirements are for Treasuries with maturities between 9year 5 months and 10 years. In comparison, the underlying of '10-Yr Treasury Note Futures' has a maturity between 6 year 6 months and 10 years.
With contract selection out of the way, the next step is to calculate the Dollar Neutral spread. This requires us to identify the DV01 of the front and back legs of the spread and try to match them. This is to ensure that the entire position remains as close to dollar neutral as possible, so we can get a 'purer' exposure to the yield difference between the front and back legs, and parallel moves are negated. CME publishes articles on this topic to explain the setting up of a DV01 spread clearer than we can explain. You can find them attached in the reference section below.
You can handily find the DV01 of the Cheapest To Deliver (CTD) securities on CME’s website.
In this case, we are looking at the 2Yr and Ultra 10Yr Treasury Futures to set up the trade. With the DV01 of the 2Yr at 34.04 and the DV01 of the Ultra 10Yr at 96.26.
The spread ratio can be calculated as 96.26/34.04 = 2.83. Rounding this to the nearest whole number, we would need 3 lots of2-Yr Treasury Future and 1 lot of Ultra 10-Yr Treasury Future, to keep the DV01 equal (neutral) for both legs of this portfolio.
Given our view of the 2Yr-10Yr yield spread turning lower, we want to short the yield spread. Yield and prices move inversely, hence, to short the yield spread, we long the Treasury Futures spread as it is quoted in price. We can long 3 ZTH3 Futures (2Y Treasury Future) and short 1 TNH3 futures (Ultra 10Y Treasury Future) to complete 1 set of the spread. However, since the 2-Yr Treasury Futures has a notional value of 200,000 while the Ultra 10Y Treasury Futures a notional of $100,000, the price ratio will be 6:1 when the position/leg ratio in the spread trade is 3:1. As such the current level would provide us with an entry point of roughly 494 with a minimal move in Ultra 10yrs representing 15.625 USD and that in 2Y representing 7.8125 USD.
While slightly more complex in setting up, this trade allows us another alternative to express the same view on the yield curve spread differential. Being able to execute the trade via different instruments allows you to pick the most liquid markets to trade or take advantage of mispricing in the markets.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.
Reference
www.cmegroup.com
www.cmegroup.com
www.cmegroup.com
www.cmegroup.com
The yield curve has to un-invert eventually… right?Those who have been reading our past 2 ideas will know we’ve been harping on and on about expected rate path and policy timelines. Why the recent obsession you ask? Because we think we’re on the cusp of major turning points.
So, for the third time, let’s look at the market’s expected policy rate path.
With FOMC coming up this week, we are expecting a 25bps hike followed by some commentary/guidance on the next cause of action. Based on CME’s Fedwatch tool, markets are expecting a last hike of 25bps in the March FOMC before a pause in the hiking cycle. Now keep that in mind.
One interesting relationship we can try to observe is how the 2Yr-10Yr yield spread behaves in relation to where the Fed’s rate is. We note a few things here.
Firstly, the ‘peak’ point of the 2Yr-10Yr spread seems to happen right around the point when rate hikes are paused. With the Fed likely to pause as soon as March, we seem to be on the same path, setting up for a potential decline in the spread.
Secondly, the average of the past 3 inversions lasted for around 455 days, and if you count just the start of the inversion to the peak, we’re looking at an average of 215 Days. Based on historical averages, we are past the middle mark and have also likely peaked, with current inversion roughly 260 days deep.
Looking at the shorter end of the yield curve, we can apply the same analysis on the 3M-10Yr yield spread.
The ‘peak’ point of the 3M-10Yr yield spread is marked closer to the point when the Fed cuts, except in 2006, while the average number of days in inversion was 219 days and the average number of days to ‘peak’ inversion was 138 days. With the current inversion at 105 days for the 3M-10Yr Yield spread, we are likely halfway, but the peak is likely not yet in. (Although eerily close to when the Fed is likely to announce its last hike, March FOMC, 51 days away).
Comparing the 2 yield curve spreads, we think a stronger case can be made for the 2Yr-10Yr spread having peaked and likely to un-invert soon.
Handily, CME has the Micro Treasury Yield Futures, quoted in yield terms, which allows us to express this view in a straightforward manner allaying the complications with DV01 calculation. We create the short yield spread position by taking a short position in the Micro 2-Yr Yield Futures and a long position in the Micro 10-Yr Yield Futures, at an entry-level of 0.623, with 1 basis point move equal to 10 USD.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.
Reference:
www.cmegroup.com
www.cmegroup.com
That's why the Fed needs to stop hiking before a system collapseThis is a quite interesting chart showing a ratio (black trend-line) of the Interest Rate, 5Y Yield and Federal Debt trading within a Megaphone pattern since the 1990s. Its (Higher) Highs have naturally coincided with peaks in Rate Hikes (red trend-line). The last peak was on October 2018 and currently the ratio just broke within that range again (red area).
This shows that the Fed is on a timer and has only limited time to act and stop hiking before they jeopardize collapsing a system that is in place for three decades now and brings balance to the market. The S&P500 (blue trend-line) has seen great periods of growth and stability systemically with this in place as long as the Fed doesn't go off limits with hiking.
Do you also think its time they act now and stop or at least ease this round of hiking before total collapse?
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Dollar pushes wobbly yen to 130The Japanese yen continues to lose ground, as USD/JPY has punched above the symbolic 130 line. In the North American session, USD/JPY is trading at 130.01 up 1.02% on the day.
The US dollar is having its way with the yen this week as USD/JPY has surged 2.23%. The driver behind the yen's plunge is an upswing in US Treasury yields. The 10-year yield rose from 2.84% to 2.93% today, and as we have often seen, the yen finds itself at the mercy of the US/Japan rate differential and is sharply lower today.
Most of the major central banks have embarked on rate-hike cycles in order to contain spiralling inflation, with the noticeable exception of the Bank of Japan. The BoJ has continued its ultra-accommodative policy, which it insists is needed to boost the fragile economy. BoJ Governor Kuroda has defended keeping interest rates low, saying that wages and service price inflation have remained modest. The BoJ continues to view cost-push inflation as transient and is not all that concerned with inflationary pressures, which are much lower than we are seeing in the other major economies.
In the US, the Fed commenced quantitative tightening this week and the Fed continues to send out hawkish messages. Fed Governor Christopher Waller fired the latest hawkish salvo from the US central bank, saying he supported more rate hikes, even above the "neutral level", which is not supportive or restrictive for growth. The Fed estimates the neutral level to be around 2.5%, which leaves plenty of room for further hikes until the neutral level is approached. Fed Chair Powell has signalled that the Fed will deliver 50-bps hikes in June and July, followed by a pause in September.
USD/JPY has broken past resistance at 1.2890 and 1.2973. The next resistance line is at 131.24
There is support at 128.01
Bullish Gartley on the TLT Visible On Weekly TimeframeI'v been tacking this Gartley for a while now and eager to post it but opted to wait until it got closer to the PCZ before i posted and now we are pretty much here; This could signal the end of Rising Treasury Yields and the beginning of a Recovery Period within Equities and Securities. I will be taking profit on my Yearly TLT PUTs and buying some Yearly CALLs next week.
XAG USD - Update to previousXAG USD during the APAC session provided a nice bottom out and pullback from the daily 61.8% touch.
Our analysis yesterday was invalidated during time of posting due to the pullback not completing but testing the main demand highlighted below in the blue zone .
We saw a great order block build and the sellers reject with bullish pressure from the demand block for structure.
Price is now showing us a great opportunity to head up to 29 again, however, remain cautious - the bearish move is still in play despite silver being 5.5%+ for the day.
But price on the higher timeframe has retraced to a demand imbalance and orders will be picked up - so from here we are expecting price to range between the 23.7 -24.00 now the zones are established the demand is in control.
See our previous trades . We have closed one trade previous and still have the original running from 14.88$.
Enjoy looking through our previous trades to follow the journey to now.
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