No Landing in the Twilight Zone

21 февр. 2023 г.

CBOT: Micro Treasury Yields (2YY1!, 5YY1!, 10Y1!, 30Y1!)
Is the US economy heading towards a “no landing”, as opposed to a “hard landing” or a “soft landing"? There is a heated debate among economists and market strategists.

What is a "no landing"? It is a new term drawn up by Wall Street, which describes the economy continuing to grow while the Fed raises interest rates to fight inflation.

Stock investors have a hard time making sense of the latest data from inflation, employment, and corporate earnings. The Fed’s future policy actions are unclear. As a result, the US stock market moved sideways in recent weeks.


Treasury Market in Disarray
With a widening negative yield curve, bond investors are convinced that a US economic recession is on the horizon. Let’s refresh our knowledge on this subject.

Yield curve shows interest rates on Treasury bonds with short-term, intermediate, and long-term maturities, notably 3-month T-Bill, 2-year and 10-year T-Notes, 15-year and 30-year T-Bonds.

Bond investors expect to be paid more for locking up their money for a long stretch, so interest rates on long-term debt are usually higher than those on short-term. Plotted out on a chart, the various yields for bonds create an upward sloping line.

Sometimes short-term rates rise above long-term ones. That downward sloping line is called yield curve inversion or negative yield curve. An inversion has preceded every U.S. recession for the past 50 years. It’s considered a leading indicator of economic downturn.

On July 21st 2022, the 2-year yield stood at 3.00%, above the 2.91% 10-year yield. Since then, we have been in negative yield curve environment for seven months. The 10Y-2Y yield spread has widened to -76.9 bps, but a recession has not yet occurred.

Below are current yields indicated by CBOT Treasury futures as of February 17th:
• 30-day Fed Funds: 4.665%
• 2-year Treasury: 4.618%
• 5-year Treasury: 4.014%
• 10-year Treasury: 3.848%
• 30-year Treasury: 3.883%

We observe that the longer the duration, the lower the yield. The 5Y, 10Y and 30Y yields all price below current Fed Funds rate target of 4.50-4.75%.

The US economy seems surprisingly strong, despite the Fed trying to cool it with eight consecutive rate hikes. However, negative yield curve contradicts the notion of “No Landing”.


Trading Opportunities in Micro Yield Futures
Investors currently expect the Fed to raise interest rates in March and June meetings, with the terminal rate consensus at 5.3% at the end of this tightening cycle.

Clearly, Treasury futures market has not priced in the pending rate hikes. The most underpriced interest rate is the 10-year yield. At 3.85%, it is 90 bps below current Fed Funds target and 1.45% below expected terminal rate.

On February 17th, the February and March 2023 contracts of CBOT 10-Year Micro Yield Futures (10Y) were quoted almost the same rate, at 3.850% and 3.853%, respectively. Investors apparently brushed off the upcoming rate increase in March.

My trading rationale: US businesses continue to expand, which provides solid support for the long-term debt market. With short-term yield rising fast, borrowers would flock to lower rate debt, pushing up demand for the longer-term credit. In my opinion, a 10-year yield below 4% is not sustainable.

For confirmation, let’s take a look at various market interest rates for 10-year duration:
• US Corporate AAA Effective Yield: 4.61%
• US Corporate BBB Effective Yield: 5.64%
• US Mortgage Rate, 10-year fixed: 6.24%
• Bank Certificate of Deposit, 10-year: 4.10% (Discover Bank)

Monthly contracts for the 10Y are listed for 2 consecutive months. Contract notional value is 1,000 index points. A minimum tick of 0.001 (1/10 of 1 bps) is worth $1. This means that a 25-bps increase will translate into $250 per contract. It would be a 77% gain in contract value if we use the $325 initial margin as a cost base.

April contract starts trading on March 1st. If it is quoted similar to the March contract, there is potential to gain. Whether we compare with market rates of debt instruments of the same 10-year duration, or with risk-free Treasury rates of different durations, a 10-year yield pricing below 4% is a bargain. Besides, the FOMC meeting on March 21st-22nd would likely give the contract a big boost, as long as the Fed raises rates. In summary, I would consider a long position for April 10Y contract at or below 4% yield.

What about the idea of yield curve reversal and the narrowing of 10Y-2Y spread? It may still happen, but its timing is unclear at this point.

Micro Yield futures are designed for shorter-term trading with contracts listing for only two calendar months. This is different from CBOT 2-year (ZT) and 10-year (ZN) futures which are listed for 3 consecutive quarters, currently through September. The traditional Treasury futures contracts would be better instruments for a yield spread strategy.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

CME Real-time Market Data help identify trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs tradingview.com/gopro/