Bloomberg calls this setup a "Fed-Proof" Bond Bet.
Whether President Donald Trump nominates Fed Board Governor Jerome Powell, Stanford University economist John Taylor or even current Chair Janet Yellen to lead the central bank, one trade is foolproof in the eyes of many on Wall Street: betting on a flatter U.S. yield curve. By most measures, the spread between short- and long-term Treasuries is already the slimmest in a decade as the Fed raises rates in the face of tame inflation.
“If they’re going to continue on this normalization path -- and whoever comes in is going to do that -- you’re just going to continue to see this flattening yield curve,” said Eric Souza, senior portfolio manager at SVB Asset Management.
The surging two-year yield, in particular, highlights how much traders have had to alter expectations for the Fed, which in 2016 projected four rate hikes but only moved once.
The markets are coming around to the Fed’s projected rate path for 2017. The implied odds that the central bank will boost rates by year-end have jumped to about 82 percent, from 65 percent at the start of the month, based on overnight index swaps and the effective fed funds rate.
Those expectations are also showing up in the futures markets. Hedge funds and other large speculators extended net-short positions on both two- and five-year Treasury futures to a record last week, according to Commodity Futures Trading Commission data through Oct. 17.
John R. Taylor, former head of the world’s biggest currency hedge fund, said last week that his analysis of statistical patterns indicates the curve flattening is done.
For now, though, it’s going to be tough for the 10-year yield to exceed 2.4 percent, a key technical level for months, said Justin Lederer, an interest-rate strategist at Cantor Fitzgerald. The yield twice flirted with that mark in October, only to retreat.
I did not think the Fed would get in another hike this year. However, the move to replace Yellen with an alleged hawk has the market convinced. The Fed is highly unlikely to disappoint.
Hurricanes have made it harder to assess the true state of the economy. Notably, there has been an inventory build to replace damaged autos. Some blame the hurricanes for housing weakness.
But housing has been slowing for six months, autos even longer. This is not a robust economy.
These "sure thing" bets are typically a contrarian indicator.
I stick with my assessment the next big move in yields is lower, not higher. Hedge funds plowing into a "sure thing" bet that 5-year yields are headed up may come to regret that decision.
Mike "Mish" Shedlock