160620 30 yr ratesA former colleague of mine – someone who used to regularly make $100+mil a year wrote a very good book.  Here is my book review.  In it he discusses “the once chart to rule them all,” which is basically to be long the very long end of the curve.  You pick up carry (coupons) and roll (that amazing rate slide down on the chart).  It’s been an amazing trade, in retrospect.  I’m of the opinion that this “Lord of the Charts” will break within 5 years.  However, that could be a long time away.  For now though, this chart, combined with my Fed view, is causing an epiphany.

As I’ve discussed the past, I think the “easier” hikes are the ones that get us to 1-1.5%.  This is because the neutral rate is perceived to be only 1% higher than we are now.  Once we get to this range, the bar for future hikes is going to be very high because you are no longer “removing excess accommodation” (taking the foot off accelerator) you are actually tightening (stepping on the brake).  Do you really need to step on the brake with 2% growth?!?

This is a change of view from before, when I thought with continued progress, we could hike more (for longer).  The hike more for longer is what the Fed is telling us through their SEP.  1.8-2% GDP growth gets us to a 3% long run FF goal.  I went along with this, since these are the people who set the rates.  But when you step back, if we are at a 1.5% FF rate, is the Fed really going to hike again with 1.9% GDP growth and 2.0% inflation?  I’m not so sure.  Why would they?  They may – I’m just saying the bar for further hiking will be much higher.

So given that: (1) the next few hikes are the easy ones, and (2) the Fed may be on hold for a while afterwards, I don’t think the highest year spreads on the curve should be blues-golds (EDH0-H1 and EDM0-M1).  This is probably a function of people getting out of flatteners and possibly getting into steepeners ahead of Brexit.  And traditionally, this makes sense… if the Fed stops hiking any hikes on the curve will get pushed back.  Except, does this logic make sense in the current environment?  Isn’t “now” (the next 12-18 months) the best time for a hike?  If the Fed does not hike “now,” you need to severely discount any future hikes – the new neutral rate will probably be lower.  I suppose if the Fed had to ease (with their 1 bullet left), this could cause the curve to steepen initially.  But after that, we are basically looking at QE.  Why couldn’t we be the next EU or Japan?  Those countries have negative rates (something the US probably won’t go to), and yet their greens-golds spread equivalent is still lower than what it is in the US.

Even Yellen mentioned the “new normal” in her last speech.  They won’t have to hike as much and the long term rate is expected to stay low.  So I’m not sure the long-end steepener makes any sense.  Note that I am speaking on a relative basis, and not an absolute basis.  The curve could steepen absolutely, but less likely relative to the rest of the curve.  So the moderate bearish scenario would be that we get bear flattening – some kind of selloff led relatively by the belly (say greens).  We would be reversing the move from the past three weeks and the 5s-10s steepener people instinctively put on in times of crisis.  The moderate bullish scenario would be some kind of bull flattener.  Basically, the global yield grab should cause the long end to perform well relatively.  The timing is a little tricky with Brexit, because of a potential ease (and further curve steepening), but this could present us with a great opportunity to get into a favorable trade.

Let’s see if we can get a good look at this around the Brexit results.

 

{This was originally published June 20, 2016]