I’ve been saying for weeks now why the curve was probably going to flatten. I discussed how the other central bank policies could act like a bungee cord, holding the longer end US rates down. Last week, we got Draghi comments that inflation can not be self-sustaining without stimulus. And we got lower-than-expected Japanese GDP. So despite the stronger US data, the longer end rallied for the week, partly because the bungee cord shows no signs of fraying.
As analysts come on TV to discuss the flattening of the yield curve, the interpretation I think is incorrect in the current environment is that the flattening yield curve is some sign of economic weakness. We are looking to have three straight quarters of 3+% GDP growth, and we should be getting some kind of stimulus early next year. The WSJ poll of economists have seen the odds of a recession at a very low 15%-ish for most of the past year. So while the curve has gotten flatter as the year has gone on, none of the flattening is because of an increase in the recession odds. The flattening is just the bungee cord in the face of robust economic growth and higher odds of near-term Fed hikes. The markets have been reluctant to price in as many hikes as the FOMC has been predicting (the people who actually do the hiking). The markets are starting to come around to the dots. So we could continue to see flattening – at least until the dam (longer end downtrend lines) get broken. It my feeling that if the Fed actually did hike four more times (once this year and three time next year, as per the SEP) because of strong economic growth and in-line inflation (or close enough), the downtrend line (the dam) will break on the longer end. This is because the FFER would be at 2.16, and I would expect some chance of the Fed not being done would be priced. The downtrend line would have also creeped lower. However, we still have a lot more hiking to be priced into the front of the curve, before we reach that scenario.
Many of these analysts then go on to say that if the curve flattened to a particular level, say 2s-10s at 40 (currently 58), they would start to get more concerned about a recession. I’m not sure this follows from what has been going on in the markets. Just because we have a bungee cord flattening the curve doesn’t mean recession odds have increased. All it may really mean is that the economy has gotten stronger and the front end is pricing in more hikes.
So our strategy of sticking to our core strategy of 2018 steepeners, both absolutely and relatively made a lot of sense. But we are currently at key levels on some ED spreads. The one I have been looking at for most of the year is EDZ8-Z0 spread.
While there has been very strong support at these levels, this is also a chart that is screaming for some stop-hunting larger player to attack. And what better time than a holiday week, where people may not be around? The price action next week could be interesting. While we may break the support, I do not see the head and shoulders completing to the down side in the current environment (barring any news). But as more hikes are priced into the front end and the downtrend line in tens is tested, we could see some piling in of flatteners if the support is broken.
The question I’ve been thinking about more lately is, what are the tail risks? It seems to me that there are two:
- If the flattening continues, the flattener folks could start pricing in a recession – i.e. a portion of the curve could start to invert. 2019 would probably be the most likely candidate. We currently have no catalyst to take the near-term hikes off the table. I’m wondering if we get further flattening, would the old-time traders and historicals algos actually start pricing in a recession? I am not a believer that further flattening from the bungee cord is the sign of a recession. However, we get new news and data all the time, any of which could signal a change in direction for the economy. And we could easily get a stock market crash on “nothing.” So it seems to me that taking a conditional “zero cost” position for a recession being priced can make sense. Especially if we continue to bear flatten.
- If the support holds in EDZ8-Z0 and the curve starts steepening, we could test the longer end downtrend line. When/If this breaks, the selloff should be led by the very long end of the curve. However, I would expect the bulk of the steepening to occur in EDZ8-Z0, as the flatteners stop out. We can see how the curve reacts and select the best location for our view.
I would like to get some of the above positioning on for later in the week – especially around the FOMC minutes. So stay tuned to the daily emails. For now, I have another Trade Thought: