Diary of a Financier

2s10s: Get Your Flatteners Ready

In Economics, Trading Desk on Tue 26 Apr 2011 at 17:50
  • With the historical effects of QE & technicals as a guide, expect yield curve flattening over the next 3 months.
  • Short-end rates to start climbing come June; long-end falling very soon.
  • Consensus expects more of an outward shift in the entire yield curve, certainly not falling LT rates.
  • Started buying LQD to capitalize on this theme.

Seems like Jeff Gundlatch and I are the only ones calling for falling rates after QE2.  The more I investigate the matter and the more opposition I cross, the more conviction I gain.  This entry adds to my outlook for the yield curve: now, not only do I expect a falling long-end (10 year+), but I’ve also come around to see the front-end rising from here on in.Here’s a previous excerpt regarding my stance on the 10-year:

Mr. Gunlatch is quite right about the correlation between QE and rising 10-year rates.  But as for what the bond market says: QE1 had little net effect on AGG, which inched up only +0.62% over the 15 month QE1 purchasing period.  Similarly, AGG has lost -0.95% to date since the QE2 purchasing began.   Although, while QE has had little effect upon [core] bonds–if anything, it seems to have faintly hindered them–it’s hard to say what would’ve happened void of the stimulus.

I wanted to add an interest rate chart to that mix.  Here’s an overlay of the yields for 3-month T-Bills (IRX) v. 10-year T-bonds (TNX):

IRX v TNX- The Effect of Quantitative Easing on the Treasury Curve

That chart emphasizes the effect of QE on these Treasury rates.  QE plunged the front-end of the curve, whereas longer rates simply rose out of neglect.  Therein, we see the true aim and the true accomplishment of Quantitative Easing: empirically, QE drove down short-term rates like IRX.  That’s where the government had the greatest presence; that’s where the government focused; and that’s [part of] why mid-to-long-term rates rose, void of government intervention. (Unfortunately, policymakers had hoped that their manipulation of the yield curve would resonate to greater impact the real economy.)

Further, that’s why the curve-flattening trade is a huge winner over the next two quarters.  Rising short-term rates is vogue on the Street right now.  That’s not a novel revelation.  But piggybacking on that notion, consensus calls for the entire yield curve rising in a parallel, outward shift.  Mr. Gundlatch & I are lonely contrarians here.  Not only is the yield curve historically steep, but using the closing months of QE1 as a guide, I expect short-term rates to start rising within an earshot of QE2’s end, with longer-rates falling even sooner.

With Ben Bernanke’s inaugural press conference tomorrow, there will be an immediate catalyst to start pushing longer-term rates down.  There’s money to be made in this 2s10s flattening conviction.  At the end of last week, I decided to scale into an Investment Grade Bond (LQD) position.  In a hold-to-maturity basket, we already own a few high yield single-names in the 1-5 year space.  So, adding LQD with its average maturity 11.87 years and duration 7.11 not only adds quality & girth to our duration exposure, but it also endorses the flattening theme discussed herein.  When a spike in volatility brings profits to our long vol hedge, I expect to reallocate the entire vol position into TLH, TLT,or some equivalent.

–Romeo

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  1. […] 4/26- Falling Rates coming, Buy Bonds in 10-year space. […]

  2. […] April 26, I made a great call for interest rate flatteners: …the curve-flattening trade is a huge winner over the next two […]

  3. […] the yield curve. One of our biggest money-makers in the first half came from a precise, contrarian call on falling 10-year rates. I had also expected short-term rates to start rising at the end of June. […]

  4. […] 2s10s: Get Your Flatteners Ready | The Buttonwood Tree – With the historical effects of QE & technicals as a guide, expect yield curve flattening over the next 3 months. Short-end rates to start climbing come June; long-end falling very soon. Consensus expects more of an outward shift in the entire yield curve, certainly not falling LT rates. […]

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