Big Bottom in BondsUS10Y/US02Y vs TLT & US10Y
Bonds tend to bottom at the same level of the ratio of 10 year yields to 2 year yields. Should we be using the ratio of long and short term yields instead of the difference to trade the Bond Market?
Yieldcurve
Bitcoin - Another sign that Fed credibility is waning.A Sick Feeling in the Belly of the Yield Curve
Another sign that Fed credibility is waning.
The socioeconomic point of view is that, as the Supercycle bear market develops, central banks will lose their mantle as being omnipotent directors of markets. Whereas in the bull market, central bankers like Alan “the Maestro” Greenspan were lauded because positive social mood was driving the stock market higher, in the bear market central bankers will be vilified as negative social mood causes a downtrend in stock prices.
Yesterday, Fed Chairman Jerome Powell sought to reassure Americans that the series of interest rate hikes that the central bank is embarking on would not tip the U.S. economy into recession. The bond market promptly ignored those soothing words and the yield curve flattened. A flattening yield curve, whereby the positive gap between short-dated bonds and long-dated bonds is narrowing, is a sign that the market is anticipating slower economic growth. When the yield curve inverts, with long-dated yields below short-dated, it has historically been a signal that an economic recession is on the horizon.
That historical relationship is most generally related to the yield spread between 2-year yields and 10-year yields, and that yield curve has been flattening over the past year from 1.50% to around 0.20% where it is currently hovering. So, not quite inverted yet, but trending in that direction.
However, in the so-called belly of the yield curve, the area between 5 and 10-year maturity, the message is already here. The chart below shows that the yield spread between 5 and 10-year U.S. Treasury yields has declined precipitously over the last year and, yesterday, turned negative. This yield curve inversion is a clue that a 2-yr /10-yr (2s 10s in industry vernacular) inversion is probably on its way.
Despite what the Fed says, a beast of a recession may be approaching.
U.S. Treasury 10-Year Yield Minus 5-Year Yield
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.
US02Y/US10Y Uninversion & RecessionsThe dynamics of the US Treasury yield curve, particularly the spread between the 2-year and 10-year yields (US02Y/US10Y), have long been studied as potential indicators of economic health. One phenomenon that garners significant attention is the inversion and subsequent uninversion of this yield curve. Lets delve into what these terms mean, their historical significance concerning recessions, and how investors might interpret these signals.
What is the Yield Curve?
The yield curve is a graphical representation showing the relationship between interest rates and the maturity of US Treasury securities. Typically, longer-term bonds have higher yields than shorter-term ones due to the risks associated with time, such as inflation and uncertainty. This normal upward-sloping curve reflects investor expectations of a growing economy.
Yield Curve Inversion
An inverted yield curve occurs when short-term interest rates exceed long-term rates. Specifically, when the yield on the 2-year Treasury note surpasses that of the 10-year Treasury bond, it suggests that investors expect lower interest rates in the future, often due to anticipated economic slowdown or recession.
Historically, an inversion of the 2-year and 10-year yield curve has been a reliable predictor of upcoming recessions. Before the last several recessions, the yield curve inverted approximately 12 to 18 months prior.
An inversion indicates that investors are seeking the safety of long-term bonds, driving their prices up and yields down, due to concerns about future economic conditions.
Uninversion refers to the process where the inverted yield curve returns to a normal, upward-sloping shape. While an inversion is a warning sign, the uninversion phase can be even more critical.
In many cases, recessions have followed shortly after the uninversion of the yield curve. This occurs as the Federal Reserve may begin cutting short-term interest rates in response to economic weakness, causing short-term yields to drop below long-term yields again.
The uninversion can signal that monetary policy is shifting in response to economic stress, potentially validating the recessionary signals that the initial inversion suggested.
The uninversion of the US 2-year/10-year yield curve is a critical event that has historically preceded economic recessions. By understanding this phenomenon and considering it alongside other economic indicators, investors can make more informed decisions. It's important to approach such signals with a comprehensive analysis and a prudent investment strategy that aligns with individual financial goals and risk tolerance.
Recession Now Well Underway The yield curve is now fully inverted after reaching EXTREME levels. With that, we can conclude the recession has officially contaminated the financial sector.
Soon (likely before year end) we will see a significant selloff in equities.
Suggest: sell stocks & buy US Treasury Bonds.
Yield Curve Reversion Trade 2024The yield curve reversion is when the US10Y Treasury Yield becomes greater than the US2Y Treasury Yield and has a track record for signalling recession. I've been tracking the reversion for the past two years for any hint of sense of whether the US FED would cut FEDFUNDS rates or if bond traders would drive yields/prices towards reversion. This time, the fed's narrative is driving the reaction here.
To express this idea I've put on long CBOT_MINI:10Y1! and short CBOT_MINI:2YY1! via the futures market. I'll keep rolling the futures contracts until the yield curve starts to form a top, likely a spread value between 1.5-3.0.
FOMC Showdown Poised to Ignite a Surge in Yield SpreadsWith inflation finally cooling and the Fed signaling rate cuts, it seems relief is on the horizon—until you look at the job market. As recession risks grow and Treasury yields falter, a steepening yield curve presents a compelling opportunity.
Positioning in the yield curve ahead of the FOMC meeting offers a more measured way to navigate the uncertainty.
COOLING CPI SIGNALS GREEN LIGHT FOR RATE CUTS
This week’s inflation report showed headline CPI cooling to 2.5%, the lowest since February 2021. With this release, inflation has finally fallen decisively below the stubborn 3% mark and is now just 0.5% above the Fed’s target range. PCE inflation reflects similar levels, likely giving the Fed the signal to start cutting rates.
JOB MARKET REPRESENTS MATERIAL RECESSION RISKS
Recent job market data suggests it may be too soon to declare a soft landing. The labor market is significantly weakening, and with household savings dwindling and credit delinquencies increasing, conditions may worsen before improving.
U.S. economic data from the past week indicates that the labor market is in a precarious situation. The August JOLTS report showed job openings dropping to their lowest since early 2021, reflecting decreased labor demand, while unemployment edged up slightly.
Additionally, the August jobs report revealed a modest gain of 142,000 non-farm jobs, falling short of expectations, with downward revision for July bringing those figures down to just 89,000.
As covered by Mint Finance previously a recession is likely to lead to a sharp steepening of the yield curve.
We covered average levels of the yield spread at the start of recessions in detail previously, but in summary with the current 10Y-2Y spreads at 15 basis points, there may be up to 85 basis points of further upside in the spread.
TREASURY YIELD PERFORMANCE
Despite a short recovery following the ominous jobs report on 2/August, Treasury yields have continued to decline. Unsurprisingly, short-dated treasuries have underperformed as 2Y yields are 27 basis points lower, while 30Y yields have only declined by 12 basis points and 10Y by 15 basis points.
Overlaying yield performance with economic releases, the largest impact on yields over the last few months has been from FOMC releases and non-farm payrolls while performance around CPI releases has been mixed. Potentially suggesting traders are more concerned about recession risk than moderating inflation.
OUTLOOK FOR SEPTEMBER FOMC MEETING
Source: CME FedWatch
FedWatch currently suggests that a 25 basis point rate cut is more likely in the upcoming FOMC meeting scheduled on September 17/18. However, probabilities of a 50 basis point rate cut are also relatively high at 43%.
Source: CME FedWatch
While the odds of a 25 basis point cut have remained in majority, the 50 basis point cut has been uncertain with probability shifting over the past week.
FOMC meetings have driven a rally in yield spreads over the past year.
With FOMC meeting slated for next week, it is interesting to note that performance in yield spread prior to meetings has been more compelling than performance post-FOMC meeting. Over the last 5 meetings, pre-FOMC meetings, the 10Y-2Y spread has increased by 4 basis points.
Performance is even more compelling in the 30Y-2Y spread which has increased by an average of 13 basis points.
AUCTION DEMAND FAVORS 10Y
Recent auction for 10Y treasuries indicated strong demand with a bid/cover ratio of 2.64, which is higher than the average over the last 10 auctions of 2.45. Contrastingly, the 30Y auction was less positive with a bid/cover ratio of 2.38, below the average of 2.42. 2Y auction was sharply weaker with a bid/cover of 2.65 compared to average of 2.94.
Auction uptake suggests higher demand for 10Y treasuries than 30Y treasuries and fading demand for near-term 2Y treasuries.
HYPOTHETICAL TRADE SETUP
Recent economic data has made an upcoming rate cut nearly certain. However, the size of the cut remains unclear. CME FedWatch currently indicates a 42% probability of a larger 50-basis-point cut, driven by the recent CPI report and weak jobs data.
With rising recession risks, the Fed might opt for a larger rate cut. However, if they choose a moderate 25-basis-point cut, market sentiment could stabilize. Historically, yield spreads around FOMC meetings suggest that positioning before the meetings tends to be more advantageous than after. This is especially relevant now, as moderating sentiment from a 25-basis-point cut could trigger a temporary reversal in yield spreads.
Considering the underperformance of the 10Y-2Y spread in September and increased auction demand for 10-year Treasuries, a long position in the 10Y-2Y spread may be the most favorable strategy for gaining exposure to the steepening yield curve.
Investors can express views on the yield curve using CME Yield Futures through a long position in 10Y yield futures and a short position in 2Y yield futures.
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 makes spread calculations trivial with a 1 basis point change in spread representing PnL 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 September 13, making this trade even more compelling.
A hypothetical trade setup offering a reward to risk ratio of 1.46x is provided below:
Entry: 14.2 basis points
Target: 35 basis points
Stop Loss: 0 basis point
Profit at Target: USD 208 (20.8 basis points x 10)
Loss at Stop: USD 142 (14.2 basis points x 10)
Reward to Risk: 1.46x
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.
One Chart to Rule them All ~ 10Y/2Y and 10Y/3M Yield Spreads10Y/2Y and 10Y/3M Yield Spread
One chart to rule them all. I have combined the 10Y/2Y Yield Spread (purple line) and the 10Y/3M Yield Spread (blue line) onto one chart. You can get updated readings on it at anytime on my TradingView page (link in bio above)
I have measured the historic timeframe from un-inversion to recession for both datasets. Un-inversion occurs when the yield spread rises back above the 0 level.
Given the 10Y/2Y Yield Spread has just un-inverted (moved above 0), I thought this a worthy exercise. The findings are interesting and useful.
Main Findings / Trigger Levels
The findings are based on the last 4 recessions (this as far back as the 10Y/3M Yield Spread chart will go);
▫️ Before all four recessions both yield spreads un-inverted (only one has to date);
- At present only the 10Y/2Y yield spread has un-inverted (2nd Sept 2024), thus we can watch for the next warning signal which is an un-inversion of the 10Y/3M yield spread. Without both yield spreads un-inverting the probability of recession is reduced.
▫️ The 10Y/2Y typically un-inverts first and the 10Y/3M un-inverts second.
-Historically the delay between the 10Y/2Y and the 10Y/3M un-inversion is between 3 to 10 weeks (23rd Sept – 11th Nov). This is the date window that we can watch for a 10Y/3M un-inversion (based on historic norms).
-If we move outside this window beyond the 18th Nov with no 10Y/3M un-inversion, then we are outside the historic norms and something different is happening. Nonetheless watching for the un-inversion of the 10Y/3M after this date could be consequential.
▫️ On the chart I have used the last four 10Y/2Y yield spread un-inversion timeframes to recession and created a purple area to forecast these from the recent the inversion on the 2nd Sept 2024 forward (Labelled 1 - 4). This creates a nice visual on the
chart. Based on these historic timeframes and subject to the follow up 10Y/3M un-inversion confirming in coming weeks, the potential recession dates are as follows (also marked on chart);
1.28th Oct 2024 (based on 2000 10Y/2Y un-inversion to recession timeframe)
2.03rd Feb 2025 (based on 2020 10Y/2Y un-inversion to recession timeframe)
3.12th May 2025 (based on 2007 10Y/2Y un-inversion to recession timeframe)
4.25th August 2025 (based on 1990 10Y/2Y un-inversion to recession timeframe)
✅ Remember, you can check in on this chart and press play to get updated data at any time by clicking the link in the comments below or by following me on TradingView👍
▫️ I will include a table in the comments which outlines all of the above metrics with dates. I will also share a chart with a zoomed in version of present day so that all the above trigger dates can be more closely monitored.
Finally, it’s important to recognize that these findings and trigger levels are based on the last four recessions. There is no guarantee that a recession will occur or occur within the set trigger levels. What we have is a probabilistic guide based on historic patterns. This time could play out very differently or not play out at all. Regardless, all of the above findings help us gauge the probability of a recession with historic timeframes to watch. It leaves us better armed to make the necessary risk adjustments, particularly if the 10Y/3M yield curve un-inverts.
Price is king, and at present, prices are pressing higher on most relevant market assets. From the above findings and the current positive market price action, it appears we have a little more time before being hauled into a longer-term correction or recession. I lean towards the later dates (2, 3, and 4 above) for this reason. Interestingly, many of my historic charts from months ago and last year suggested Jan/Feb 2025 (also option 2 above) as a very high-risk period. You can view these charts under the above specific chart on TradingView.
This chart is your one-stop shop for checking recession trigger levels based on historic timeframes for both yield spreads. You can update this chart data anytime on my TradingView page with just one click. Be sure to follow me there to access a range of charts that will help you assess the direction of the economy and the market. Thanks again for coming along!
Remember, you can check in on this chart and press play to get updated data at any time by clicking the link in the comments below or by following me on TradingView.
Thanks
PUKA
10y/2y Treasury Yield Curve cant make up its mind10y/2y Treasury Yield Curve
⏳ Just cant make up its mind......
I wonder what Friday's stamp will be
10y/2y Treasury Yield Spread Un-inverts 10y/2y Treasury Yield Spread Un-inverts
Something just popped its head above the 0 level on the daily chart over the past 3 days.
Read my post below to understand what this means
PUKA
Lower inflation do not mean things will become cheaperLower inflation and interest rates do not necessarily mean that prices will decrease. If I annualize the inflation numbers instead of focusing on the monthly figures, the overall picture becomes much clearer.
2 and 10 Year Yield Futures
Ticker: 2YY, 10Y
Minimum fluctuation:
0.001 Index points (1/10th basis point per annum) = $1.00
Disclaimer:
• What presented here is not a recommendation, please consult your licensed broker.
• Our mission is to create lateral thinking skills for every investor and trader, knowing when to take a calculated risk with market uncertainty and a bolder risk when opportunity arises.
CME Real-time Market Data help identify trading set-ups in real-time and express my market views. 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
Yield CurveThe 2/10 treasury yield spread is quickly flattening and an inversion could happen soon.
All of the previous yield curve inversions are associated with memorable market sell-offs and recessions.
I believe the ripple effect of the ongoing financial and economic sanctions against Russia will end up being the catalyst for the next meltdown.
The market conditions have been favorable to a disaster by many measurements for some time now.
Again, there are many unknown cross-currents beginning to work their way into the global economy. On top of that, the FED is raising interest rates in less than two weeks.
Rapid Yield Curve Inversions as Recession Fears RealizedLast week was pandemonium for US Equities, Japanese Equities, Foreign Exchange markets, Cryptocurrency markets, and Bond markets. Yet, for those positioned for the normalization of the yield curve, results are apparent as the curve has officially normalized into positive territory with a sharp recovery on Friday which continued into Monday.
The non-farm payroll report highlighted concerns we previously illustrated that a recession is not off the cards yet.
In fact, the latest data suggests it may be likely. The Sahm rule, a strong indicator of past recessions, was activated based on the latest jobs data.
Given the possibility of a recession in the US, the further steepening of the yield curve remains a compelling opportunity with uncertainty persisting across all areas of the market. This paper provides a hypothetical trade setup in the 10Y-2Y spread to gain exposure to normalization.
LATEST JOB REPORT WAS DISMAL WITH LOW JOBS ADDED, RISING UNEMPLOYMENT
The Nonfarm payroll report from July showed a meagre 114k jobs added compared to expectations of 176k. Even worse, figures for May and June were revised lower by a cumulative 29k bringing the updated figures well below the initial analyst consensus for these months.
Job addition in July was one of the lowest since the pandemic. Moreover, both initial and continuing jobless claims last week rose to their highest level since 2021. Combined effect on the job market was an increase in the unemployment rate to 4.3%, the highest since 2021.
The job market is visibly weakening. Though the effect of Hurricane Beryl likely played a role in the dismal jobs report, the details suggest systemic weakening as both hiring and quits fell to their lowest level since 2020.
To make matter worse, conditions may worsen even further in the coming months as Intel announced plans to reduce its workforce by 15k at its most recent earnings.
JOBS REPORT TRIGGERS SAHM RULE
The Sahm rule is a recession indicator used to identify early signals of a recession. It measures the difference between the current unemployment rate relative to the lowest three-month average in the last 12 months. According to the Sahm Rule, a recession could be on the hoirzon when this value rises above 0.5, Currently, the indicator is at 0.53.
It is a highly accurate indicator, proven to be reliable through the last 12 recessions when the indicator was at present values.
While no indicator is completely accurate and past results do not guarantee future performance, the accuracy of the indicator should not be ignored.
RATE CUT EXPECTATIONS SURGE
As a result of the dismal jobs report, rate cut expectations have surged, largely due to expectations that the Fed will be forced to cut rates rapidly in response to a faltering economy.
For reference, at the September policy meeting, FedWatch signals a >90% probability of 50 basis point cuts. Just 1 week ago, FedWatch suggested a 10% probability for that decision.
Source: CME FedWatch
Markets are also expecting a 50-basis point cut at the November meeting followed by a 25-basis point cut at the December meeting for a cumulative cut of 125 basis points in 2024.
Source: CME FedWatch
BOND MARKETS IN TURMOIL BUT YIELD SPREAD SURGED
Due to the rapid reversal in sentiment, US treasury yields have fallen sharply. 2Y yield is 15% lower over the past week. 10Y yield has declined by 10% and 30Y yield has fallen by 8%.
On Friday, the decline in 2Y yield was the sharpest since 13/December when the Fed policy projections suggested up to six rate cuts in 2024. This time around, the decline in bond yield has been driven by market fears of a recession which may force the Fed to cut rates rapidly.
While the yields have declined sharply, yield spreads have surged. The 10Y-2Y spread has increased by 27 basis points over the past week with a 10-basis point jump on Friday followed by another 8 basis points increase on Monday.
The 30Y-2Y spread has been the strongest performer. It has increased by 63 basis points over the past week. It surged by 29 basis points on last Friday and another 14 basis points on Monday.
Both spreads have now normalized as 2Y yield has declined much more sharply than 10Y and 30Y yield. The normalization has brought to end the longest yield curve inversion in history that lasted more than two years.
This is not unexpected as highlighted by Mint Finance in a previous paper . The yield spread tends to normalize long before a recession actually arrives.
However, the spread may rise further. According to historical levels of the 10Y-2Y spreads at the start of previous recessions, there is between 15 and 100 basis points of further upside.
The potential for upside is even higher on the 30Y-2Y spread although in 1989, the level was lower than the current level suggesting the risk of a decline.
LONG 10Y SHORT 2Y ON FURTHER NORMALIZATION
While the movements in the yield spreads over the past week have been enormous, there is a potential for further increase. Recession signals are flashing red. Equity markets are in turmoil. Fed may be forced to reduce rates to support a weak job market.
Rapid rate cuts and a recession support further steepening of the yield curve. Historical performance of yield spreads prior to recessions suggests the yield curve may continue to steepen at a rapid rate.
We had previously suggested the 30Y-2Y spread as a superior instrument to express views on this normalization. However, the 30Y-2Y spread has surged by 63 basis points in the past week. While it may continue to rise even further, there is a risk that markets have exhausted much of the upside. A position on the 10Y-2Y spread offers potentially higher upside.
The 10Y-2Y spread is just above the level of 0 indicating the potential for further recovery. The current 10Y-2Y spread level is far below the levels at the start of previous recessions.
Investors can seize opportunities from normalization in the 10Y-2Y spread using CME Yield futures. The CME Yield futures are quoted directly in yield with a one basis point change in the yield representing a P&L of USD 10.
The below hypothetical trade setup consisting of long 10Y yield futures and short 2Y yield futures expresses a view on the further steepening of the yield spread with a reward to risk ratio of 1.3x.
Entry: 3.7
Target: 27.8
Stop Loss: -15
Profit at Target: USD 241 ( (27.8 – 3.7) x 10 = 24.1 x 10)
Loss at Stop: USD 187 ( (-15 – 3.7) x 10 = -18.7 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 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.
Front-Running Yield Curve Normalisation on Rate Cut AnticipationThe (in)famous Yield Curve remains inverted. In recent past, spreads normalized only to revert to inversion as rate cut expectations got pushed out. This time though, is different.
Recent CPI print has significantly altered market sentiment. The likelihood of an initial rate cut at the September FOMC meeting now exceeds 90%. Consequently, the yield curve is normalizing once more. Current market signals indicate that this normalization could be enduring.
WHY IS THE YIELD CURVE INVERTED?
The present yield curve inversion indicates that investors do not expect that rates will remain this elevated for long. While 2Y treasuries continue to be re-issued at higher rates, expectations for longer terms such as 10Y and 30Y are lower as they factor in that rates will normalize from their present levels.
YIELD CURVE WILL NORMALIZE SOON, WHAT WILL DRIVE IT?
While this is the longest period of yield curve inversion in history, the curve has started to normalize. The factors driving normalization in the yield curve were previously discussed. Ordinarily investors demand higher rates for longer-duration treasuries to account for the higher inflation expectations and greater risk.
Either inflation must fall, or inflation adjusted treasury yields for longer maturities must rise.
Rate cuts will also drive the normalization in the yield curve. The yield spread between 2Y & 10Y treasuries tends to rise in the two months preceding the first rate cut in a cutting cycle as observed in the past.
The impact of rate cuts on the 2Y-10Y spread is even more pronounced in the two months following the first-rate cuts.
UNCERTAINTY IN MACRO ECONOMIC DATA IS DISSIPATING
Make no mistake, the broader picture remains uncertain. However, recent data points to recovery. Chicago PMI showed a sharp recovery in July. But the job market signals uncertainty.
Continuing jobless claims remain elevated. Job openings have fallen. But job creation in the last two non-farm payroll prints were above expectations.
US Retail sales and industrial production have improved. The impact can be observed through the consistent increase in the GDPNow forecast for Q2 GDP since 12/July.
Source: GDPNow
The June CPI release showed uncertainty easing. Headline CPI cooled sharply as it fell on a MoM basis. Notably, the stickier core CPI also continued to cool as it fell to 3.3%. However, inflation remaining sticky at the 3% level remains a grave concern.
Even if a recession does arrive in the coming months, the 10Y-2Y yield spread is likely to have normalized by then. Yield curve inversion is observed only before recessions not during.
RAPID RATE CUTS EXPECTED IN THE COMING YEAR
Source: CME FedWatch
The rate cuts outlook has improved substantially. FedWatch signals that rates will fall by 100 basis points by March 2025 (as of 19/July) suggesting successive cuts.
Other analysts are even more optimistic. Analysts at Citi bank hold the view that rates will be slashed by 200 bps (2% in total), starting in September across eight successive FOMC meetings (25 bps at each) by the summer of 2025.
CERTAINTY IN RATE OUTLOOK SUGGESTS YIELD CURVE NORMALIZATION
Major moves in the yield curve have only come through after commencement of rate cuts in the past. This time, markets may front-run these expectations.
The attempts to front-run rate cuts were already observed in December when the yield spread recovered sharply after the Fed signaled six potential rate cuts in 2024.
Presently, the 10Y-2Y yield spread is trading below those levels and has the potential to break out as we approach September rate cuts. The risk of a reversal remains but it is lower.
Higher rates pose a systemic risk for the US given its profligate borrowing. Higher rates on treasuries are untenable for much longer.
Cost of servicing public debt in June hit USD 140 billion and totaled USD 868 billion in the first nine months of the current fiscal year (33% higher YoY). For reference, the total budget deficit for this period was $1.27 trillion. The interest burden is weighing heavily on the overall budget deficit.
HYPOTHETICAL TRADE SETUP
Treasury auctions are a sound guide to maturities selection when positioning for yield curve normalization.
The recent demand for treasuries at the latest auctions has been low. Bid-to-cover ratio for all (2Y, 5Y, 10Y, and 30Y) was lower than the average bid-to-cover over the prior ten auctions. Demand was weak for the 10Y treasuries. Demand for 30Y treasuries has also been lower than previous auctions but has remained more consistent than 10Y.
The yield spread between 30Y-2Y treasuries has outperformed the 10Y-2Y spread over the past 2 months.
Investors can seize opportunities from normalization in the 30Y-2Y spread using CME Yield futures. The 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, to calculate the spread P&L is equally intuitive with a one basis point change in the spread between two different maturities also equal to USD 10.
The hypothetical trade setup consisting of long 30Y and short 2Y is described below.
• Entry: -2.6 basis points (bps)
• Target: +25 bps
• Stop Loss: -25 bps
• Profit at Target: USD 276 (27.6 bps x USD 10)
• Loss at Stop: USD 224 (22.4 bps x USD 10)
• Reward to Risk: 1.24x
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.
Yields are still selling off after yesterday's dropLet's see how the TVC:VIX does over the next few days/weeks.
Still think it eventually breaks its major support level, at least temporarily.
The 2Yr and 10Yr are crashing and following yesterdays drop. TVC:TNX
#interestrates, as we said, will likely be cut, even if a little. They will most likely be raised again next year. Not political...
Anyway, since we have stated COUNTLESS times. They CANNOT lower rates but MUST lower them.
Yield Curve Inverts Further on Rising Recession Risk As the tides of economic fortune ebb and flow, a spectre of recession looms over the horizon, whispering in the rustling of Treasury yields and the shifting sands of macroeconomic indicators.
Recent economic data has painted a complex tableau of financial uncertainty. From declining PMI figures to a palpable deceleration in GDP growth, the economic forecast has shifted, stirring speculations that Fed may be forced to cut rates should the US economy slip into recession.
Uncertainty around the timeline of rate cuts plus a potential looming recession are causing the yield curve to invert once more. Investors can obtain exposure using CME yield futures with a reward to risk ratio of 1.6x.
RECESSION SIGNALS ARE FLASHING AGAIN
Monetary policy winds are starting to shift once more. Recent economic data, including PMI figures, and a sharply weaker GDP in the US have led participants to increase their expectations that the US Federal Reserve (“Fed”) will have to relent and cut rates in 2024.
Source: CME FedWatch
Over the past month, probability of a rate cut at 7/Nov policy meeting has increased from 42% to 47%. More notably, the probability of a second rate cut at the 18/December policy remains slightly elevated over the past week at 35%.
Typically, rate cuts suggest that the Fed is nearing its dual goals of maximum employment and stable prices. However, current expectations for rate cuts may stem from distinct reasons.
Inflation remains persistent. Fed officials remain steadfast in their battle against inflation. But inflation is stalled at 3%. Higher rates are instead starting to impact economic growth. As rates remain high, the odds of an economic slowdown rise.
On 4/June, job openings in the US fell to their lowest level in three years. On 31/May, the Chicago PMI indicator fell sharply into what is a recession territory.
Q1 GDP was revised lower last month. Weak consumption data from the US has led to expectations that GDP growth during Q2 may remain slow.
On a similar note, the household jobs survey showed full-time employment declining by 625k in May while part-time employment rose by just 286k. However, not all jobs’ data was negative. The establishment jobs survey showed strong job creation at 272k far higher than expectations of 182k. Additionally, wage growth was above expectations as weekly average earnings rose 0.4% compared to 0.2% in April.
The household survey counts each individual only once, regardless of how many jobs they have. In contrast, the establishment survey counts employees multiple times if they appear on more than one payroll.
Many observers have been calling for a recession in the US ever since the Fed raised rates to their highest level in 23 years. Yet the US economy has remained robust. Part of the reason behind the resilience has been the savings cushion that US consumers built up during the pandemic. However, with the strong inflation during the past year, most of that cushion has been spent. Consumers have already started to shift their consumption habits and credit usage (and delinquency) has been on the rise.
Credit card delinquencies are at the highest level in more than a decade and personal savings built up during the pandemic have been exhausted.
ECONOMIC DATA DRIVES BOND YIELDS LOWER AND RE-INVERTS YIELD CURVE
Throughout the past 10 days, economic releases in the US have driven bond yields consistently lower. Recent non-farm payrolls data drove a rally in yields.
Economic releases have also driven a decline in the yield spreads resulting in further inversion of the yield curve. Since the release of the PCE price index and Chicago PMI on Friday 30/May, the 10Y-2Y spread has declined by nine basis points.
The 30Y-2Y spread has performed the worst since then as it stands ten basis points lower.
Further, unlike the uptick in yields following NFP, the yield spreads continued to invert further, especially for the 30Y-2Y and 10Y-2Y spread.
HYPOTHETICAL TRADE SETUP
Historically, the yield spread between 10-year and 2-year Treasuries tends to normalize by the time a recession officially hits the US. Based on current trends, a recession, as indicated by GDP metrics, might not occur until early next year.
Currently, the yield curve is deeply inverted, and recession signals are intensifying. Moreover, the possibility of a rate cut remains uncertain. This ongoing uncertainty about the policy direction is further exacerbating the inversion of the 10Y-2Y spread.
Another factor to consider is the upcoming US elections. As the Fed strives to remain an independent authority, they may opt to avoid major policy moves before elections are concluded.
This week is set to bring several key economic updates, including the May CPI report and the Federal Reserve's revised economic projections. These projections are expected to reveal that rate cuts, previously anticipated for 2024, might be delayed further.
The volatility in economic data has made it challenging to assess the yield trends. Despite a general rise in yields, the yield curve continues to invert, particularly the 30Y-2Y spread, which has been the most adversely affected. This reflects ongoing investor concerns about long-term Treasuries as expectations for rate cuts are pushed further into the future.
Source: CME CurveWatch
Investors can obtain exposure to a further inversion in the 30Y-2Y spread using CME 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 equal to USD 10.
The hypothetical trade setup using the 30Y-2Y spread is described below.
• Entry: -36.5 basis points (bps)
• Target: -50 bps
• Stop Loss: -28 bps
• Profit at Target: USD 135 (13.5 bps x USD 10)
• Loss at Stop: USD 85 (8.5 bps x USD 10)
• Reward to Risk: 1.59x
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.
Bond Yields about to crater?GOOD MORNING!
The 2Yr & 10Yr have broken the triangle pattern we posted on long ago.
The TVC:TNX (10Yr) has gone lower compared to the 2Yr in the same time frame.
Again, natural normalization is still out the window! What does this point to?
Will fed do what they are good at & mess it up again?
---
Now look @ the 10Yr on a weekly chart!
AH HA! Are Bond #yields about to crater???
Inverted Yield of 2022 Explained - Till TodayFor our housing loan, many of us, if you are in your 30s today and all the way to 70 years of age, will likely have chosen floating or short-term loan rates rather than longer-term loan rates. However, everything changed in 2022. Now, we are more likely to choose longer-term loan rates over floating rates. Why? Because today, longer-term loan rates are lower than floating rates.
This phenomenon is called an inverted yield curve.
In the 70s and 80s, there was also a period of inverted yields, and different markets moved accordingly as expected. Today, we are seeing an inverted yield once again, and the same markets are moving in a manner similar to those in the 70s and 80s.
We will do a comparison between the 70s and today’s inverted yield. Please let me know what opportunities you see after this tutorial.
2 Year Yield Futures
Ticker: 2YY
Minimum fluctuation:
0.001 Index points (1/10th basis point per annum) = $1.00
10 Year Yield Futures
Ticker: 10Y
Minimum fluctuation:
0.001 Index points (1/10th basis point per annum) = $1.00
Disclaimer:
• What presented here is not a recommendation, please consult your licensed broker.
• Our mission is to create lateral thinking skills for every investor and trader, knowing when to take a calculated risk with market uncertainty and a bolder risk when opportunity arises.
CME Real-time Market Data help identify trading set-ups in real-time and express my market views. 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
We have a Grey Rhino here - Markets are driven by ignoranceThe US long-term bonds have hit new lows, the yield curve has been inverted for two years now, and inflation remains uncertain, meaning interest rates may not ease at all. Yet, stock markets are reaching new highs.
We have a "grey rhino" in this market. A grey rhino is a large and visible animal that cannot be ignored. Try not to get too close to them because when they start charging, we can never outrun them.
In this market context, we face a big, obvious problem that investors completely ignore until it becomes a crisis. It's different from a "black swan," which is a rare and unpredictable event.
When we recognize that there are problems many do not understand, we have already won half the battle.
U.S. Treasury Bonds Futures & Options
Ticker: ZB
Minimum fluctuation:
1/32 of one point (0.03125) = $31.25
2-Year Yield Futures
Ticker: 2YY
Minimum fluctuation:
0.001 Index points (1/10th basis point per annum) = $1.00
Disclaimer:
• What presented here is not a recommendation, please consult your licensed broker.
• Our mission is to create lateral thinking skills for every investor and trader, knowing when to take a calculated risk with market uncertainty and a bolder risk when opportunity arises.
CME Real-time Market Data help identify trading set-ups in real-time and express my market views. 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
Navigating Interest Rates with Micro Yield Futures Pair TradingIntroduction to Yield Futures
In the complex world of financial markets, Treasury Yield Futures offer investors a pathway to be exposed to changes in U.S. treasury yields. Among these instruments, the Micro 10-Year and Micro 2-Year Yield Futures stand out due to their granularity and accessibility. These futures contracts reflect the market's expectations for the yields of U.S. Treasury securities with corresponding maturities.
Micro 10-Year Yield Futures allow traders to express views on the longer end of the yield curve, typically influenced by factors like economic growth expectations and inflation. Conversely, Micro 2-Year Yield Futures are more sensitive to changes in the federal funds rate, making them a ideal for short-term interest rate movements.
Why Pair Trading?
Pair trading is a market-neutral strategy that involves taking offsetting positions in two closely related securities. This approach aims to capitalize on the relative price movements between the two assets, focusing on their correlation and co-integration rather than their individual price paths. In the context of Micro Treasury Yield Futures, pair trading between the 10-Year and 2-Year contracts offers a strategic advantage by exploiting the yield curve dynamics.
By simultaneously going long on Micro 10-Year Yield Futures and short on Micro 2-Year Yield Futures (or vice versa), traders can hedge against general interest rate movements while potentially profiting from changes in the yield spread between these maturities.
Analyzing the Current Market Conditions
Understanding the current market conditions is pivotal for executing a successful pair trading strategy with Micro 10-Year and Micro 2-Year Yield Futures. Currently, the interest rate environment is influenced by a complex interplay of economic recovery signals, inflation expectations, and central bank policies.
Central Bank Policies: The Federal Reserve's stance on interest rates directly affects the yield of U.S. Treasury securities. For instance, a hawkish outlook, suggesting rate hikes, can cause short-term yields to increase rapidly. Long-term yields might also rise but could be tempered by long-term inflation control measures.
Strategic Approach to Pair Trading These Futures
Trade Execution and Monitoring
To effectively implement a pair trading strategy with Micro 10-Year and Micro 2-Year Yield Futures, traders must have a solid plan for identifying entry and exit points, managing the positions, and understanding the mechanics of yield spreads. Here’s a step-by-step approach:
1. Identifying the Trade Setup
Mean Reversion Concept: In this strategy, we utilize the concept of mean reversion, which suggests that the yield spread will revert to its historical average over time. To quantify the mean, we employ a 20-period Simple Moving Average (SMA) of the spread between the Micro 10-Year and Micro 2-Year Yield Futures. This moving average serves as a benchmark to determine when the spread is significantly deviating from its typical range.
Signal Identification using the Commodity Channel Index (CCI): To further refine our entry and exit signals, the Commodity Channel Index (CCI) is employed. The CCI helps in identifying cyclical turns in the spread. This indicator is particularly useful for determining when the spread has reached a condition that is statistically overbought or oversold.
2. Trade Execution:
Going Long on One and Short on the Other: Depending on your analysis, you might go long on the Micro 10-Year Yield Futures if you anticipate the long-term rates will increase more relative to the short-term rates, or vice versa.
Position Sizing: Determine the size of each position based on the volatility of the yield spreads and your risk tolerance. It's crucial to balance the positions to ensure that the trade remains market-neutral.
Regular Review and adjustments: Regularly review the economic indicators and Fed announcements that could affect interest rates. Keep an eye on the spread for any signs that it might be moving back towards its mean or breaking out in a new trend.
Contract Specifications
To further refine our strategy, understanding the specific contract details of Micro 10-Year and Micro 2-Year Yield Futures is crucial:
Micro 10-Year Yield Futures (Symbol: 10Y1!) and Micro 2-Year Yield Futures (Symbol: 2YY1!):
Tick Value: Each tick (0.001) of movement is worth $1 per contract.
Trading Hours: Sunday to Friday, 6:00 p.m. to 5:00 p.m. (New York time) with a 60-minute break each day beginning at 5:00 p.m.
Initial Margin: Approximately $350 per contract, subject to change based on market volatility.
Pair Margin Efficiency
When trading Micro 10-Year and Micro 2-Year Yield Futures as a pair, traders can leverage margin efficiencies from reduced portfolio risk. These efficiencies lower the required capital and mitigate volatility impacts.
The two charts below illustrate the volatility contrast: the Daily ATR of the yield spread is 0.033, significantly lower than the 0.082 ATR of the Micro 10-Year alone, nearly three times higher. This lower spread volatility underlines a core advantage of pair trading—reduced market exposure and potentially smoother, more predictable returns.
Risk Management in Pair Trading Micro Yield Futures
Effective risk management is the cornerstone of any successful trading strategy, especially in pair trading where the goal is to mitigate market risks through balancing positions. Here are key risk management techniques that should be considered when pair trading Micro 10-Year and Micro 2-Year Yield Futures:
1. Setting Stop-Loss Orders:
Pre-determined Levels: Establish stop-loss levels at the outset of the trade based on historical volatility, maximum acceptable loss, and the distance from your entry point. This helps in limiting potential losses if the market moves unfavorably.
Trailing Stops: Consider using trailing stop-loss orders that move with the market price. This method locks in profits while providing protection against reversal trends.
2. Position Sizing and Leverage Control:
Balanced Exposure: Ensure that the sizes of the long and short positions are balanced to maintain a market-neutral stance. This helps in minimizing the impact of broad market movements on the pair trade.
Leverage Management: Be cautious with the use of leverage. Excessive leverage can amplify losses, especially in volatile market conditions. Always align leverage with your risk tolerance and market assessment.
3. Regular Monitoring and Adjustments:
Adaptation to Market Changes: Be flexible to adjust or close the positions based on significant changes in market conditions or when the initial trading assumptions no longer hold true.
4. Utilizing Risk Management Tools:
Risk Management Software: Set alerts on TradingView to help track the performance and risk level of your pair trades effectively.
Backtesting: Regularly backtest the strategy against historical data to ensure it remains effective under various market conditions. This can also help refine the entry and exit criteria to better handle market volatility.
Effective risk management not only preserves capital but also enhances the potential for profitability by maintaining disciplined trading practices. These strategies ensure that traders can sustain their operations and capitalize on opportunities without facing disproportionate risks.
Conclusion
Pair trading Micro 10-Year and Micro 2-Year Yield Futures offers traders a sophisticated strategy to exploit inefficiencies within the yield curve while mitigating exposure to broader market movements. This approach leverages the distinct characteristics of these two futures contracts, aiming to profit from the relative movements between long-term and short-term interest rates.
Key Takeaways:
Market Neutral Strategy: Pair trading is fundamentally a market-neutral strategy that focuses on the relative performance of two assets rather than their individual price movements. This can provide insulation against market volatility and reduce directional risk.
Importance of Strategy and Discipline: Successful pair trading requires a disciplined approach to strategy implementation, from trade setup and execution to ongoing management and exit. Adhering to a predefined strategy helps maintain focus and objectivity in trading decisions.
Dynamic Market Adaptation: The financial markets are continuously evolving, influenced by economic data, policy changes, and global events. A successful pair trader must remain adaptable, continuously analyzing market conditions and adjusting strategies as needed to align with the current economic landscape.
Comprehensive Risk Management: Effective risk management is crucial in pair trading, involving careful consideration of position sizing, stop-loss settings, and regular strategy reviews. This ensures sustainability and longevity in trading by protecting against undue losses.
By maintaining a disciplined approach and adapting to market changes, traders can harness the potential of Micro Treasury Yield Futures for strategic pair trading, balancing risk and reward effectively.
When charting futures, the data provided could be delayed. Traders working with the ticker symbols discussed in this idea may prefer to use CME Group real-time data plan on TradingView: www.tradingview.com This consideration is particularly important for shorter-term traders, whereas it may be less critical for those focused on longer-term trading strategies.
General Disclaimer:
The trade ideas presented herein are solely for illustrative purposes forming a part of a case study intended to demonstrate key principles in risk management within the context of the specific market scenarios discussed. These ideas are not to be interpreted as investment recommendations or financial advice. They do not endorse or promote any specific trading strategies, financial products, or services. The information provided is based on data believed to be reliable; however, its accuracy or completeness cannot be guaranteed. Trading in financial markets involves risks, including the potential loss of principal. Each individual should conduct their own research and consult with professional financial advisors before making any investment decisions. The author or publisher of this content bears no responsibility for any actions taken based on the information provided or for any resultant financial or other losses.
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.
The future of Interest RatesRough map pf rate expectation without pretension of accuracy for dates nor timing...
Normalization of Yield Curve on its own is in dangerGood Morning Everyone
We finally see what we were expecting. That was the expectation for #Yields to pump higher.
There was a NORMALIZATION of the yield curve taking place. However, the 2Yr has moved faster than 10Yr today.
IF the #FederalReserve drops rates causing the normalization of the curve it could cause the end of this bull run. The best scenario would be the normalization to happen in its own.
