An Uncharted Landscape of Prolonged Yield Curve Inversion

13 Mei

CBOT: Micro 2-Year Yield (2YY1!) and Micro 10-Year Yield (10Y1!)
The recent US inflation cycle started in June 2020. As the global pandemic interrupted the global supply chain, the prices of goods began to rise rapidly. In the following two years, the headline CPI shot up nearly nine percent to a 40-year high.

The Federal Reserve initially judged inflation to be transitionary and sat on the sideline for almost two years. However, when it finally came into action, it did so decisively with a campaign of aggressive interest rate increases. The hikes started in March 2022 and went on for ten more times, pushing the Fed Funds rate up 525 bps, from 0-25 bps to 5.25-5.50%.

Has the Fed tightening policy been successful? Yes and No. On the one hand, inflation rate dropped nearly 2/3 from the peak of 9.1% in June 2022 to 3.5% in March 2024. We are not yet back to the 2% policy target but are on the right track.

On the other hand, price levels remain stickily high. According to the “CPI Inflation Calculator” by the Bureau of Labor Statistics, the purchasing power of $1.22 in March 2024 equals that of $1.00 in December 2019. This means that the average price in the US has gone up 22% since the start of the pandemic. Even though the inflation rate is moving down, price levels continue to move up.

After hiking interest rates 11 times and pausing 6 times, the Fed now has a dilemma. “To cut, or Not to cut”, this is a trillion-dollar question. Adding to the complexity of the situation is that we have been in a negative yield curve environment for two years.

The Persistent Yield Curve Inversion
Yield Curve shows how interest rates on government bonds compare, notably three-month Treasury Bills, two-year and 10-year Treasury Notes, 15-year and 30-year Treasury Bonds. Bond investors expect to be paid more for locking up their money for a long stretch, so interest rates on long-term debt are higher than those on short-term. Plotted out on a chart, the various yields for bonds create an upward sloping line.

Sometimes short-term rates rise above long-term ones. That negative relationship is called yield curve inversion. An inversion has preceded every U.S. recession for the past half century, so it’s seen as a leading indicator of economic downturn.


The chart above shows a downward slopping Treasury yield curve on May 12th. We observe that 3MO Bill currently yields 5.391%, while the 10Y Note yields just 4.5%, which is 89 bps lower.

Financial markets use the yield spread of 10Y and 2Y Notes as a benchmark for yield curve relationship. In a normal interest rate environment, the 10-2 yield spread is a positive number. On July 21st, 2022, 2Y yield stood at 3.00%, above the 2.91% on 10Y yield. This was the first time in ten years that the 10-2 spread turned negative (-9 bps).

Almost two years later, the yield curve inversion remains in effect. On May 12th, the 10Y yield, the 2Y yield, and the 10-2 spread are 4.50%, 4.87% and -37 bps, respectively.

Under an unprecedented period of negative yield curve, how the shifting of Fed policy would impact interest cost of long- and short-duration remains to be seen.

Trading with CBOT Micro Yield Futures
The complexity of yield curve inversion makes analyzing interest rates extremely difficult. We could narrow down the analysis on the two key points of the yield curve, the 2Y and the 10Y. The underlying Treasury bonds are among the most liquid financial instruments in the world. The 10-2 spread trades are also very popular for interest rate investors.

We could simplify our analysis into the following:
• To formulate a viewpoint on the future direction of the 2Y yield;
• To formulate a viewpoint on the future direction of the 10Y yield;
• To formulate a viewpoint on whether the 10-2 spread will be widened or tightened.

From a trading perspective, if you have confidence in any one of the three, you could develop a trading strategy by using CBOT Micro Treasury Yield Futures.

Last Friday, the June contract of Micro 2Y Yield futures (2YYM4) were settled at 4.722%. Each contract has a notional value of 1,000 index points, or $4,722 at current price. To buy (long) or sell (short) 1 contract, a trader is required to deposit an initial margin of $340.

The June Micro 10Y Yield (10YM4) was settled at 4.489%. Notional value is 1,000 index points or $4,489. Initial margin is $320.

The 10Y-2YY yield spread for June contract is -23.3 bps (= 4.489 - 4.722). A long (short) spread trade involves buying (selling) one 10Y futures and shorting (buying) one 2YY futures simultaneously. It requires an initial margin of $660 (= 340 + 320).

My thought below is for your information only. First, on the 2YY:
• You could decompose the 2Y yield into 24 consecutive 1M rates over a 2-year period. The negative 37 bps between the Fed Funds rate and 2Y yield may be considered the weighted average of these 1M rates, with the expectations of Fed cutting rates.
• The Fed is unlikely to raise rates again. But it remains highly uncertain when it will start cutting rates and how often it will do.
• Consequently, the 2YY could fluctuate in the short-term, but would decline over time.
• To express this view, a short 2YY futures rollover strategy may be appropriate.
• My last idea on May 6th includes a detailed explanation on futures rollover strategy. Let’s recap the long futures rollover here:
o In April, buy (going long) a June contract.
o In June, short the June contract to close the existing position. Buy an August contract and reestablish a long position.
o The trader would repeat the above steps, so far as he holds a bullish view.
o A short futures rollover will be the exact opposite of the above.

My thought on the 10Y:
• The Fed rate hikes had a lagging effect on longer term rates. While mortgage rate, auto financing, business loan and credit card rate have all risen substantially, 10Y yield is still priced at 1 full percentage point below the Fed Funds rate. Due to the cumulative effect of past interest rate hikes, mortgage rates and auto loan rates are still rising, even though the Fed has paused.
• Would the Fed rate cuts, applied on the overnight rate only, bring down the long-term interest rates? In my view, it takes a series of cuts to reverse the negative yield curve. In a presidential election year, the Fed is unlikely to make abrupt policy shifts.
• The uncertainty with long-term yield makes it risky to do an outright directional trade.


My thought on the 10Y-2Y spread:
• We have been in a negative yield environment for nearly two years, without having experienced an economic recession. This is an uncharted territory.
• In my opinion, the US economy is very resilient. Growth may be slowed, but a recession is unlikely. Massive government deficit spending would continue to pour money into the system, supporting business growth, full employment and robust consumer spending.
• The 2Y yield is affected directly by the Fed. It would decline in the next two years due to the expected Fed rate cuts.
• The 10Y yield is both impacted by the Fed actions and the market demand for long-term debt. It has been rising while the Fed kept the rates unchanged. Future rate cuts would slow the rise but may not be sufficient to push it downward.
• On balance, 2YY would likely fall faster than 10Y. Mathematically, it would translate into a wider 10Y-2YY spread.
• To express this view, a long 10Y-2YY spread trade may be appropriate.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

CME Real-time Market Data help identify trading set-ups 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 tradingview.com/cme/