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
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