A Quick Update on the Curve Trade

It’s been an up and down few weeks for the curve. The 2s 10s curve steepened into the volatility of early August where the yen carry unwind met disappointing jobless numbers and was amplified by growth concerns. After almost entering positive territory, the curve flattened as volatility receded. The market was buoyed by the BOJ saying no more short-term hikes, although calling 15 bps a hike is a bit of a stretch, maybe a nudge? Still, the BOJ’s dovish about-face coupled with strong retail sales assuaged concerns and the curve topped (bottomed?) out 16bps flatter before Jay Powell’s Jackson Hole pivot:

“The time has come for policy to adjust”

Short-end rates are headed down and the curve is headed steeper. At least that’s the fat part of the distribution of probable outcomes…

As of this morning (8/29/24) the 2s/10s curve is -2 bps.  Nominally 6 bps steeper than my post on 8/2/24. If you engaged the steepener amid the volatility expecting the Fed to activate “beast mode” and slash rates you instead got more of the reticent dove and a gentler glide path lower, but still a slightly steeper curve.  

At least you made some money, right?

Well, remember the negative carry of the trade? Net the curve move and negative carry, the trade is down ~6 bps (part of the curve move includes a negative roll to the new 2 year).

It’s hard to get this right, and remember the Fed is an unreliable narrator. Not purposefully. They are limited by mostly backward-looking data and inherent economic biases. It’s a common handicap of most investment managers when using macro forecasts to make investment decisions.

Without a more sophisticated process you could wait for the Fed to actually cut rates before buying the 2 Yr—as I mentioned, it’s a fairly reliable indicator to engage the steepener, at least in the last few cycles.

The caveat here is that each of the Fed hiking cycles post ‘99 ended in a crisis that amplified the bull steepener, as rates were cut to the bone (if you think the narrative of a soft landing holds then spend some time forecasting the path of the components of the trade to weigh your carry costs vs. upside):

• 2000 to 2001 the Fed cut rates by 550 bps, 2s/10s steepened by 73 bps 6 months after the first cut.

• 2007 to 2008 the Fed cut rates by 500 bps, 2s/10s steepened by 96 bps 6 months after the first cut.

• 2019 to 2020 the Fed cut rates by 200 bps, 2s/10s steepened by 5 bps 6 months after the first cut.

That’s an avg. return of 46 bps after 6 months and 113 bps after 12 months (source: Bloomberg). Sounds pretty good until you realize that the return was negative in 2020 both 6 and 12 months out.

So, engage the steepener, close your eyes and pop your head out on Groundhogs day? Maybe. It’s not the worst trade I’ve seen, and odds are in your favor. The tails are fat, though, and if inflationary data disappoints (geopolitical upward pressure on oil could do it) it’s not going to be pretty.

One thing is certain, though, you’ll pay for the privilege of finding out.

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