The 2Yr Treasury Roars into August

Do we have an all-clear on the curve steepener?

All data is as of August 2, 2024

In the first two days of August, the 2-year treasury dropped by 38 basis points. It’s down about 88 basis points since the end of June, a three standard deviation move. Put another way, that’s a move you would expect less than 0.25% of the time. Once every 360 months or 30 years!

Despite exhibiting fat left tails and slight leftward skew (cuts come faster than hikes), this is still quite a move! Since 1994, the distribution of the 2-year’s monthly change can be seen in Exhibit 1.

Exhibit 1: The Recent Move in the 2Yr Treasury was Extreme          

Why such a sudden plummet in yield? Macro mavens are better prepared to answer: lousy jobs numbers, mediocre earnings, immaculate disinflation and lower growth are driving equities down and pulling front-end yields with them. The risk off trades are here, and high-growth AI darlings like NVDA have proved themselves mortal.

So yeah, stuff is going down.

Nothing is going down more than the yield on the 2-year, which can smell the weak hand the Fed is holding. If things are as bad as the market thinks, the Fed is once again behind the curve and will need to cut further and faster than the market was pricing in just weeks ago.

We could finally see a material steepening of the yield curve.

Investors have anticipated the eventual dis-inversion of the curve and have sought to capitalize through a “steepener” trade. This entails being long the 2-year and short the 10-year, betting on a return to normalcy and a positively sloped yield curve. Exhibit 2 helps explain the logic of the steepener trade. The 2-10 Spread is seldom negative, usually preceding periods of economic distress like the Dotcom Bubble and the 2008 Global Financial Crisis. In both instances, when the bubble bursts, short end yields fall as the fed cuts rates and a steeper, positively sloped curve emerges. A profitable trade … at least in theory.

Exhibit 2: The 2s/10s Curve is Threatening to Enter Positive Territory     

For those holding a steepener, the recent run in the 2-year is great news, right? Kind of.

How great depends on when the steepener was engaged. Holding a steepener when the curve is inverted can be punishing. It’s like buying volatility or equity puts. There is a cost to waiting for things to get ugly enough for the Fed to cut rates.

That cost is typically referred to as a negative carry trade and has a couple of components.

A yield disadvantage and a roll disadvantage.

When you buy the 2-year you need to buy roughly four times as much as the 10-year that you short to keep the trade neutral and unexposed to a parallel rate shift in the curve.

To fund that extra 2-year exposure you need to borrow at rates that are typically higher than the yield of your 2-year bond. Remember the curve is inverted. You might assume that this phenomenon is temporary, but in the meantime, you are bleeding to cover the difference between your interest payments and the yield on the bonds you financed.

The second piece of the negative carry/negative roll also has to do with the curve inversion. The 2-year rolls up towards the Fed rate. Every day you hold the 2-year, its yield goes up and its price goes down – at a much greater rate than the decay of the 10-year.

So, despite the recent increased price of your 2-year, how you feel about the trade depends on how long you’ve had it on and the price you paid for it (spread). One way to visualize the tradeoff is to graph the return of the trade over time with a common return horizon. For each date we plot the return of holding a steepener from that date until Friday 08/02/2024. The steepener is 100% long the 2-year and short a duration weighted amount of 10-years.

Exhibit 3: The Stark Reality of Holding a Steepener Trade Over Time 

The curve (yellow line) inverted in 2022 as the Fed aggressively (and belatedly) hiked rates. From a low of more than negative 100 basis point the curve has steepened back to almost 0 basis points.

The return (blue line) has been mostly negative for entering the trade at any point.

On average, if you had entered a steepener at any point in the last two years you would have lost 40 basis points.

So how do you know when to engage the steepener?

Let’s look at previous cycles of inversion and use that data as a guide for when to engage:

Yikes! We are almost positive on the curve (-8 bps as of Friday August 2) and the return is still negative.

Clearly something else is needed to effectively trade the curve …

We’ll be addressing better approaches to generating alpha on the curve in a future piece, but I’ll close with some thoughts. Please note, this is not a recommendation for any sort of investment or trade.

I’m often wrong on macro (and some micro) and that’s why we have a systematic framework to support us at Thresher. Data and process trumps finger in the wind analysis every, scratch that, most of the time.

1. Carrying costs aside, we are most likely headed into a period where steepening dominates curve action in both rate directions (ask me about bear steepeners). Our models, which ran with a flattener for part of the last year, have had us firmly ensconced in a large steepener over the last few weeks.

2. There is a fairly reliable indicator for engaging the steepener—the Fed actually cutting rates. The downside is a lot of the juice is gone but for the novice it’s what I’d look for.

3. And if you are going the route of number 2, giving up on bear steepeners and waiting for blood in the water and the Fed in action, there are other ways to generate return. Long duration, volatility and gold all come to mind.

There is room for more detail and discussion, but I wanted to get something out in a timely fashion. It’s not every day we see the 2 year generate almost half a year’s worth of return in the blink of an eye.

As always, reach out with any questions.

Disclosures

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