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ST Note - Nothing but yield curve

Bonds
junvum-kim-400x400_360
Junvum Kim

Sales Trader

Summary:  Further flattening or inversion is possible but with the recent downshift consensus with descending inflation numbers, it would be worth watching for trade setup by buying the spread - buy 2 year futures ZTH3 and sell 10 year futures ZNH3 - with reward risk that could favor a steepener instead.


Chinese market returns after a long break but this week is huge with heaps of market events starting with FOMC rate decision followed by the earnings of three trillion market cap stocks – AMZN, GOOGL and AAPL - then of course non farm payroll (est 175k) and unemployment (est 3.6%) to wrap things up.
S&P500 has already started the new year with YTD return +6% breaking above psychological level 4,000 where both 200DMA & downtrend (from all time high 4,818) coincided.  As a result of this laggy looking Santa rally, S&P500 PE is nearly 20 times compared to low 17 back in October last year and so far 143 companies reported with +0.9% sales and +2% earnings surprises.

Last Friday two stocks stood out in relation to the inflation expectations.  AMEX 4Q results showed record quarterly card spending and indicated 2023 guidance for sales & earnings topping estimates.  Further more, similar to BHP that reached all time high $50 level recently, Caterpillar (CAT) has hit record high $266.04 heading into earnings tomorrow night and the focus is expected to be on the machinery producer’s demand forecast for this year.
Another observation is on silver (XAGUSD) that has gained ~40% from last year’s support level $18 while testing big downtrend (from double top $30 that was formed during 2020 – 2021).  Given its industrial uses and half precious metal status, China reopening anticipation seems to be fully priced in and major driver behind the recent base metals that also have rallied and is showing resilience. 

This month so far, broad based US dollar weakness coincided with falling VIX below 20 and credit spread declining towards 450bps on the back of falling treasury yields in the range between 20 and 40 bps particularly from 2 years onwards.  However the below graph shows shifts in yield curve of key tenors between now and 15th dec 22 when the last FOMC meeting took place with economic projections including non-accelerating inflation rate of unemployment (NAIRU) at 4% and PCE price index of 2%.  Clearly the big swings – rise in yield – were concentrated on the short end of the curve all the way upto three months while 10 year & 30 year increases were relatively subdued therefore resulting in bear flattener (short end rising faster than long end).

Most recent unemployment rate was 3.5% that is the lowest in 50 years and below NAIRU 4% so there is about 0.5% gap in between.  Also last week’s Dec core PCE YoY was 4.4% - the lowest out of four measures of inflation - therefore both of these figures still seem to suggest inflationary condition still exists hence current futures market’s implication of mere two 25bps hikes next two meetings taking the terminal rate at around 4.9% looks to be far from the reality so USD weakness may not last for long – particularly against AUD (S&P500 sensitivity) and JPY (carry trade) that both had the biggest returns of 6% among G10 currencies post last FOMC meeting - with potential reversal being a scenario that shouldn’t be ruled out.

Another component of the yield curve other than direction of yield is anticipating whether the curve will steepen or flatten.  Two of the mostly watched spreads – 2y10y (-70bps) and 3m10y (-110bps) - have been extremely inverted for some time hence raising the probability of recession based on the historical correlations.  Major driver behind the inversion of the yield curve has been a significant rise in short end of the curve reacting to Fed’s rate hikes in typical fashion and may continue to see further flattening or inversion but with the recent downshift consensus with descending inflation numbers, it would be worth watching for trade setup by buying the spread - buy 2 year futures ZTH3 and sell 10 year futures ZNH3 while matching duration or DV01 (dollar value of 1 basis point change) - with reward risk that could favor a steepener instead, should the inflation remains elevated above the Fed’s target longer than expected alongside record low level of unemployment while also we have seen AU (7.8%) & NZ (7.2%) with higher than expected CPI last week.

e.g. Long 100 lot ZTH3 and short 52 lot ZNH3 with spread ratio of 0.5169 (DV01 of $34.11 / $65.98) in the anticipation of profiting from steepening either by long end yield rising faster than short end yield (bear steepener) or short end yield falling faster than long end yield (bull steepener) but loss from more flattening and breakeven from parallel shift which is probably most unlikely scenario.

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Yield curve shift
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2y10y and 3m10y of yield curve spreads

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