Trading the Inverted Yield Curve (Part 2)

Following up from Part 1, I'd now suggest that STPP ETN could be the most hassle-free candidate to trade the inverted yield curve, but take note of its expiry date (13 August 2020). STPU ETF is another candidate, but the data points are too few to assess if it would have good tracking. We can possibly first trade the STPP and then "roll" it over to STPU nearing expiry.

The risk I'd like to address here is transmission risk - risk that the trade vehicle does not deliver on its expected results. We might get the call right, but if the vehicle gives poor tracking, it'll be a shame.

Make your own assessment and take the trade according to your risk appetite. For me, it's more for fun because these come only once a decade or so.


Is this time different?

First we have to get a sense of what are the likely scenarios in the next 1-2 years:

Recession - this should give us the best outcome on the steepening bet as the near yields would decline faster than the far yields.

No recession - the 2YR and 10YR rates would likely peg each other closely like in 1995-2001, and we need to wait for the next recession to trigger the steepener.

The major phases can be summarized as such:

< 1990 No clear trend in spreads
1990 - 1992 Yields falling, spread widens Recession
1993 - 1995 Yields rising, spread slowly narrows Expansion
1995 - 2000 Spread continues to slowly narrow Rates fluctuate, expansion
2001 - 2003 Yields falling, spread widens Recession
2004 - 2007 Yields rising, spread narrows Expansion
2008 - 2011 Yields falling, spread widens Recession
> 2011 Yields flat / slowly rising, spread narrows Expansion

There is a good amount of similarity between the 1993-2000 phase and the current phase in that both feature strong, prolonged bull markets and a slowly declining yield spread.

In addition, the instance in 1995 where the spread is near 0 and then both of the rates go lower in sync is very similar to what is happening right now. In that line, what may occur next is a prolonged wait before the steeepening occurs.


How good is STPP for tracking?

The rolling beta is too choppy for any use, so instead we will look at major inflection points on the 2YR-10YR Spread, and focusing on the dates from when the STPP is available.

The drag effect that you see is not so much due to STPP as it is due to the index that it attempts to track. The index does not do too good a job in tracking the spread. As stated on the website:

"Reasons why this might occur include: market prices for underlying U.S. Treasury bond futures contracts may not capture precisely the underlying changes in the U.S. Treasury yield curve; the index calculation methodology uses approximation; and the underlying U.S. Treasury bond weighting is rebalanced monthly."

The beta (sensitivity of the STPP price to the yield spread) can vary quite widely. It's a crude measure, but gives a ballpark figure of what we can expect. The effect seems a bit asymmetrical - down moves are of a higher beta - which is not good. Also note the small recent uptick in spread did not translate to any gains in the price - in fact, price went down slightly.

However, note that we are only looking at fractals of one leg of the cycle. These intermittent fluctuations could well be overwhelmed (in a favourable way) in the next major leg up.

Of course, the it could also be that the leg up of the cycle suffers from the low beta problem as well. Which direction, I'm uncertain, but it may not matter that much.

Below are 20-day and 60-day correlations on the values and on the daily % change in prices. Again, this is a more granular detail which I believe will be flushed away with the tide on the next leg up. The minor concern here is that the correlations can be zero or negative at some points in time, despite giving it a 60-day period (3 months).


Targets and stops

From the first chart, we can reasonably expect the spread (when it steepens) to return to previous historical levels of 2.0 to 2.5.

The mechanics of the pricing is not easy to estimate because of the way it's structured - the index multiplier and the monthly rebalancing.

A simplistic assumption of the STPP price would be for it to return to its $40+ level - where it coincided with the 2.5 spread level.

The spread could go to -0.5 as per previous inversions, or worse but unlikely to -2.5. This might roughly translate to a price of $20 and $0.


Continue reading "Trading the Inverted Yield Curve (Part 2)"

Trading the Inverted Yield Curve

Recent headlines are all about the yield curve being inverted and how low yields are now. Generally when there's such consensus and focusing on the extremes in the news, I like to see if there are any opportunities to be traded.

You can skip to the recommendated implementation in Part 2 or go to the bottom of this page for the implementation of the synthetic position

First, on the low rate environment

The problem is that it is not so simple as to go short on bonds (long yields) in hope that since it's at a historical low, it will rebound. The reason is because we are likely at the late stage of the business/economic cycle, and there's the looming risk that equity markets will undergo a correction of some degree soon. When that happens, it's almost certain that rates will be lowered even further to cushion the fall. Therefore it is not unlikely that rates go even lower from where they are right now.

Next,  on the inverted yield curve

This is a better play in terms of likelihood. The inversion of the yield curve is a relative play and we can implement a long-short strategy to benefit from the eventual steepening of the curve.  If a recession happens, this will take a little longer. If there's no recession and the economy chugs on, then the curve should become steeper sooner as confidence is regained.

Which spread to trade

While the focus is usually on the 2YR-10YR spreads, we can take a look at the other combinations to see which one is the most 'underpriced' now compared to its historical values.

This turns out to be the 1MO-10YR spread, but this is not readily implementable. Thus, we will look at implementing the benchmark 2YR-10YR spread.








There are ETFs that directly track this. Examples are the new STPU, and the older STPP (ETN). You can even try shorting the ETF FLAT. The problem with these are the illiquidity (spread costs) and the expense ratio.

A cheaper DIY way is  to use the bond ETFs for the short end and the long end: SHY and TLT. These 2 tickers respectively target the  1-3 years and the 20+ years portion of the curve. Going long on SHY and short TLT is akin to trading the yield spread, as we can see how they move in similar fashion, though not perfectly.  

You can also attempt the trade using futures /ZN and /ZT if you have access and margin.

Below are some details to consider for the SHY-TLT synthetic position. The rolling correlation uses the 60-day change in level (not percentage) and a 60-day rolling window.



Synthetic position (1x SHY - 1x TLT)

Note of caution - the SHY was not very responsive to the 2YR rates (and thus also the resulting price spread vs yield spread) pre-2009, but it seems to be ok now.

To execute this spread as a steepener, we will need to long SHY and short TLT, one unit each.

Currency Macro – Buy USDJPY – Update #3

Update of previous post 

  • Following partial close at 114.50 (FX weekly post), be wary of adding new positions now as risk sentiment is not friendly
  • Exiting long AUDJPY (currently at 80) position as current risk sentiment is not favourable for this pair in particular.
    • Firstly, there is a lack of positive drivers for AUD: relatively lower rates for AUD (compared against historical levels and against USD) and no expected pickup in growth rates globally.
    • Secondly, sentiment is turning to safe havens, which will hit AUD and increase JPY.
    • Thus the move in this pair may be the most amplified if the current factors continue to play out. Skew is therefore not great and it's better to stay away from this for now.

2018 USDTRY short

Short USDTRY on high yield, fading EM stress, and positive convexity

Entry @ 6.0 or better

P&L curve for short 0.1 lots USDTRY @ 6.0

Interest rates are at 24% in Turkey, and this yield can be harvested via buying the Turkish Lira, since most lack access to buy Turkish sovereign bonds.

1-year Forward rates are priced around 22% yield, and retail avenues can offer up to 17% in 1y swaps.

In addition to yield, price movements favour TRY gains if the stress in the EM region subsides, which is likely to pan out if a long term view is held.

Positive convexity adds to the benefits of the trade, and a hard stop loss can be set at 12.0 for an equivalent gain at 4.0.

Cryptocurrencies update

The self-perpetuating cycle has gone in reverse and it is clear now that the majority of holders were not willing to hold it for long term - i.e. they were only holding it for ST gain. Once the prospects of ST gain started to evaporate, the buyers disappeared as well.

Price drops were not only the result of selling, but an unwillingness of buyers to step in at market prices - they were only buying on much lower dips. This hurts the value for LT holders, as a lack of new buying activity has the net effect of depressing the price.

ETH and XRP are not getting the 'fundamental' boost from their ability to change things in finance, and it's clearer now (given BTC's resilience) that in the world of crypto, perception of status is more highly valued than potential of the coin, at least for now.

Going forward, the impetus for the coins remain to be seen translated into prices, and with the lack of hype, price gains will be difficult. It thus remains in the speculative and volatile category of assets, more fit for trading ST and too much uncertainty to be held LT.