Navigating The Inverted Yield Curve
The US Government runs a large budget deficit which in turn has helped enrich several emerging markets by creating a massive market for their products and services.
These deficits are financed by issuance of treasuries. Given US’ global heft, treasuries are considered “risk-free” assets, held by institutions and other central banks as reserves.
Investors hold treasuries. Many participate in the liquid CME Treasury Futures market to hedge their debt portfolios against interest rate volatility while gaining exposure to change in yields.
Unprecedented steep rate hikes with expectations of higher for longer rates, the yield curve has reached inversion levels unseen in 42 years.
With near term rates set to spike even more, a long position in near term contract combined with a short position in longer maturity treasury futures, with an entry at -79.7 basis points (bps) and a target of -142.4 bps, and hedged by a stop loss at -35.6 bps, is likely to deliver a reward-to-risk ratio of 1.4x.
US’ PROFLIGATE BORROWING IS FINANCED BY TREASURIES
The US Government can afford to and has been a profligate borrower. It has run a deficit each year since 2001. In fact, it has had budget surplus only five (5) times in the last fifty (50) years, as mentioned in our previous paper.
The US Treasury Department finances the deficit by issuing Treasury Bills (< 1 year maturity), Notes (maturities between 2 to 10 years), & Bonds (more than 20-year maturities). These securities pay a fixed return and can be redeemed at face value at maturity.
FACTORS IMPACTING TREASURY RATES
Many factors influence treasury rates. Key among them is (a) Supply & Demand, (b) Fed Rates, (c) Economic growth rates, and (d) Inflation.
Supply and Demand
Two primary sources of supply. First, the US Government. The borrowing needs of the Government shapes the size of supply. All things being equal, increased supply pushes bond price lower and the yield higher.
When Fed sells, supply increases. When the Fed buys treasuries, it causes supply to shrink and thereby influences bond yields.
Fed Rates
Treasury rates are different from Fed rates. Fed rates have an enormous impact on Treasury rates. Fed rates function as the benchmark for all other interest rates including treasury rates. However, longer term rates are not just affected by the current rates but also by the future policy path.
Short term treasuries trade tightly in tandem with the benchmark Fed rates. The longer-term treasuries do not move in lockstep as they factor in future expectations.
The correlation between Fed rates and treasury rates across different short-term maturities breaks during periods of policy changes.
Economic Growth Rates
During periods of strong economic growth higher yielding corporate debt are more attractive to investors relative to Treasuries causing demand contraction for the latter.
Higher economic growth usually results in inflation prompting central banks to raise interest rates. Combined impact of this sends treasury yields higher.
Conversely, slow growth presses yield lower.
Inflation
High inflation typically warrants central bank intervention. These have a major impact on treasury yields. Inflation reduces the real returns of the treasuries prompting higher yields to compensate for inflation led erosion.
Inflation is a concern for longer term debt holders as the present value of future cash-flows are adversely affected.
These factors together drive changes in the yield and price of US treasuries having varied effect across different maturities which can be observed along the yield curve.
THE YIELD CURVE
The yield curve sheds light on future expectations of interest rates, growth, and inflation. Under normal conditions, the yield curve slopes upwards implying greater returns to compensate for higher risk from holding long-term debt including inflation led value erosion.
Presently, the yield curve exhibits steep backwardation (downward slope) indicating lenders need for higher risk compensation in the near-term relative to longer maturities.
This term structure is referred to as yield curve inversion. An inverted yield curve has in the past been a credible indicator of near-term recession expectations, and subsequent rate cuts.
Inverted yield curve, simply put, refers to the fact that the yield of US two-year Treasury Bonds is higher than that of of US ten-year treasury.
Yield curve inversion at the extremes presents opportunities for the astute investor. The CME Group’s Micro Treasury Futures enable investors to shrewdly participate in rate markets.
COMPREHENDING US INTEREST RATE DYNAMICS
In its most recent meeting, the US Fed paused rates hike. FOMC meeting minutes made it clear that Fed is not done with hiking.
Better-than-expected GDP reading and a resilient labour market create ample space for further rate hikes. The June FOMC meeting minutes show that 16 out of 18 Fed officials (89%) expect at least one more rate hike while 12 out of 18 (67%) expect two more hikes.
Meanwhile, CME’s Fedwatch tool shows an 89% probability of a rate hike in July with many anticipating another hike after that.
Because of unprecedented steepest rate hikes on record, the spread between the 2-Year & 10-Year Notes has inverted to levels unseen since 1981.
SIGNALS FROM COMMITMENT OF TRADERS (COT) REPORT
What’s next for US interest rates? The COT shows that institutional asset managers have been increasing their net long positioning in Treasury Futures since the start of Fed rate hiking cycle while leveraged funds (hedge funds) have been increasing their net short positioning.
Over the last few weeks, positioning in shorter maturity bonds have continued to trend similarly while a plateau is observed in the longer-maturity futures indicating that the yield for long-duration bonds may not rise much higher.
Overall, institutional investors are still expecting rates to go higher this year but also positioning for the spread between short and long-duration yields to widen further.
OPTIONS MARKET SENTIMENTS
US 2Y Treasury Note options have a put call ratio of 0.76 while US 10Y Note options have a put call ratio of 0.86.
Both indicate more calls than puts, expecting bond prices to rise and yield to fall. Notably, the put/call ratio is far lower for August expiries than September expiries.
CME MICRO TREASURY FUTURES PRODUCT SUITE
The CME Group offers a wide range of products. According to Trading View statistics, CME’s rates & treasury bond derivatives trade a daily notional of USD 5.6 trillion and 7.5 million lots.
Based on notional values, the bond derivatives market is 6x larger than equity index derivatives and 45x larger than energy derivatives market.
Micro Treasury Futures are more intuitive as they are quoted in yields and are cash settled. Each basis point change in yield represents a USD 10 change in notional value.
These products reference yields of on-the-run treasuries and settled daily to BrokerTec US Treasury benchmarks ensuring price integrity and consistency.
Micro Treasury Futures are available for 2Y, 5Y, 10Y, and 30Y maturities enabling traders to take positions across the yield curve.
TRADE SET UP
With rates expected to go higher, even at the risk of economic disruption, the yield curve is expected to invert even more. To express this view, investors can use CME’s Micro Treasury Futures.
A long position in the Micro 2-Year yield futures would benefit from higher rates while a short position in the Micro 10-Year yield futures would benefit from the increasing risks of economic slowdown caused by higher rates for longer.
With near term rates set to spike, a long position in near term contract combined with a short position in longer maturity treasury futures, with an entry at -79.7 basis points (bps) with a target of -142.4 bps, and hedged by a stop at -35.6 bps, is likely to deliver a reward-to-risk ratio of 1.4x.
• Entry Level: -0.797 (-79.7 bps)
• Stop Level: -0.356 (-35.6 bps)
• Target Level: -1.424 (-142.4 bps)
• Loss at Stop: USD 441
• Profit at Target: USD 627
• Reward/Risk: 1.4x
Micro Treasury Futures provide margin offsets for spreads. For this spread, a margin offset of 50% is available which makes the total margin requirement for this position 50% x (USD 370 + USD 320) = USD 345.
These micro contracts simplify the spread trade P&L arithmetic as all contracts are of the same size. The spread value can be used to directly to compute the P&L. Every one basis point move in the spread represents a P&L change of USD 10.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. 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/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
These deficits are financed by issuance of treasuries. Given US’ global heft, treasuries are considered “risk-free” assets, held by institutions and other central banks as reserves.
Investors hold treasuries. Many participate in the liquid CME Treasury Futures market to hedge their debt portfolios against interest rate volatility while gaining exposure to change in yields.
Unprecedented steep rate hikes with expectations of higher for longer rates, the yield curve has reached inversion levels unseen in 42 years.
With near term rates set to spike even more, a long position in near term contract combined with a short position in longer maturity treasury futures, with an entry at -79.7 basis points (bps) and a target of -142.4 bps, and hedged by a stop loss at -35.6 bps, is likely to deliver a reward-to-risk ratio of 1.4x.
US’ PROFLIGATE BORROWING IS FINANCED BY TREASURIES
The US Government can afford to and has been a profligate borrower. It has run a deficit each year since 2001. In fact, it has had budget surplus only five (5) times in the last fifty (50) years, as mentioned in our previous paper.
The US Treasury Department finances the deficit by issuing Treasury Bills (< 1 year maturity), Notes (maturities between 2 to 10 years), & Bonds (more than 20-year maturities). These securities pay a fixed return and can be redeemed at face value at maturity.
FACTORS IMPACTING TREASURY RATES
Many factors influence treasury rates. Key among them is (a) Supply & Demand, (b) Fed Rates, (c) Economic growth rates, and (d) Inflation.
Supply and Demand
Two primary sources of supply. First, the US Government. The borrowing needs of the Government shapes the size of supply. All things being equal, increased supply pushes bond price lower and the yield higher.
When Fed sells, supply increases. When the Fed buys treasuries, it causes supply to shrink and thereby influences bond yields.
Fed Rates
Treasury rates are different from Fed rates. Fed rates have an enormous impact on Treasury rates. Fed rates function as the benchmark for all other interest rates including treasury rates. However, longer term rates are not just affected by the current rates but also by the future policy path.
Short term treasuries trade tightly in tandem with the benchmark Fed rates. The longer-term treasuries do not move in lockstep as they factor in future expectations.
The correlation between Fed rates and treasury rates across different short-term maturities breaks during periods of policy changes.
Economic Growth Rates
During periods of strong economic growth higher yielding corporate debt are more attractive to investors relative to Treasuries causing demand contraction for the latter.
Higher economic growth usually results in inflation prompting central banks to raise interest rates. Combined impact of this sends treasury yields higher.
Conversely, slow growth presses yield lower.
Inflation
High inflation typically warrants central bank intervention. These have a major impact on treasury yields. Inflation reduces the real returns of the treasuries prompting higher yields to compensate for inflation led erosion.
Inflation is a concern for longer term debt holders as the present value of future cash-flows are adversely affected.
These factors together drive changes in the yield and price of US treasuries having varied effect across different maturities which can be observed along the yield curve.
THE YIELD CURVE
The yield curve sheds light on future expectations of interest rates, growth, and inflation. Under normal conditions, the yield curve slopes upwards implying greater returns to compensate for higher risk from holding long-term debt including inflation led value erosion.
Presently, the yield curve exhibits steep backwardation (downward slope) indicating lenders need for higher risk compensation in the near-term relative to longer maturities.
This term structure is referred to as yield curve inversion. An inverted yield curve has in the past been a credible indicator of near-term recession expectations, and subsequent rate cuts.
Inverted yield curve, simply put, refers to the fact that the yield of US two-year Treasury Bonds is higher than that of of US ten-year treasury.
Yield curve inversion at the extremes presents opportunities for the astute investor. The CME Group’s Micro Treasury Futures enable investors to shrewdly participate in rate markets.
COMPREHENDING US INTEREST RATE DYNAMICS
In its most recent meeting, the US Fed paused rates hike. FOMC meeting minutes made it clear that Fed is not done with hiking.
Better-than-expected GDP reading and a resilient labour market create ample space for further rate hikes. The June FOMC meeting minutes show that 16 out of 18 Fed officials (89%) expect at least one more rate hike while 12 out of 18 (67%) expect two more hikes.
Meanwhile, CME’s Fedwatch tool shows an 89% probability of a rate hike in July with many anticipating another hike after that.
Because of unprecedented steepest rate hikes on record, the spread between the 2-Year & 10-Year Notes has inverted to levels unseen since 1981.
SIGNALS FROM COMMITMENT OF TRADERS (COT) REPORT
What’s next for US interest rates? The COT shows that institutional asset managers have been increasing their net long positioning in Treasury Futures since the start of Fed rate hiking cycle while leveraged funds (hedge funds) have been increasing their net short positioning.
Over the last few weeks, positioning in shorter maturity bonds have continued to trend similarly while a plateau is observed in the longer-maturity futures indicating that the yield for long-duration bonds may not rise much higher.
Overall, institutional investors are still expecting rates to go higher this year but also positioning for the spread between short and long-duration yields to widen further.
OPTIONS MARKET SENTIMENTS
US 2Y Treasury Note options have a put call ratio of 0.76 while US 10Y Note options have a put call ratio of 0.86.
Both indicate more calls than puts, expecting bond prices to rise and yield to fall. Notably, the put/call ratio is far lower for August expiries than September expiries.
CME MICRO TREASURY FUTURES PRODUCT SUITE
The CME Group offers a wide range of products. According to Trading View statistics, CME’s rates & treasury bond derivatives trade a daily notional of USD 5.6 trillion and 7.5 million lots.
Based on notional values, the bond derivatives market is 6x larger than equity index derivatives and 45x larger than energy derivatives market.
Micro Treasury Futures are more intuitive as they are quoted in yields and are cash settled. Each basis point change in yield represents a USD 10 change in notional value.
These products reference yields of on-the-run treasuries and settled daily to BrokerTec US Treasury benchmarks ensuring price integrity and consistency.
Micro Treasury Futures are available for 2Y, 5Y, 10Y, and 30Y maturities enabling traders to take positions across the yield curve.
TRADE SET UP
With rates expected to go higher, even at the risk of economic disruption, the yield curve is expected to invert even more. To express this view, investors can use CME’s Micro Treasury Futures.
A long position in the Micro 2-Year yield futures would benefit from higher rates while a short position in the Micro 10-Year yield futures would benefit from the increasing risks of economic slowdown caused by higher rates for longer.
With near term rates set to spike, a long position in near term contract combined with a short position in longer maturity treasury futures, with an entry at -79.7 basis points (bps) with a target of -142.4 bps, and hedged by a stop at -35.6 bps, is likely to deliver a reward-to-risk ratio of 1.4x.
• Entry Level: -0.797 (-79.7 bps)
• Stop Level: -0.356 (-35.6 bps)
• Target Level: -1.424 (-142.4 bps)
• Loss at Stop: USD 441
• Profit at Target: USD 627
• Reward/Risk: 1.4x
Micro Treasury Futures provide margin offsets for spreads. For this spread, a margin offset of 50% is available which makes the total margin requirement for this position 50% x (USD 370 + USD 320) = USD 345.
These micro contracts simplify the spread trade P&L arithmetic as all contracts are of the same size. The spread value can be used to directly to compute the P&L. Every one basis point move in the spread represents a P&L change of USD 10.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. 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/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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