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.

 

Appendix

Levels and changes for major inflection points for the 2YR-10YR Spread, and corresponding levels/changes for the STPP prices

Spread Price % Chg % Chg Beta Chg Chg Beta
26/8/2010 1.99 48.11
4/2/2011 2.91 54.83 0.46 0.14 0.3021 0.92 6.72 7.3043
22/9/2011 1.52 40.56 -0.48 -0.26 0.5449 -1.39 -14.27 10.2662
25/7/2012 1.21 34.45 -0.20 -0.15 0.7386 -0.31 -6.11 19.7097
31/12/2013 2.66 42.05 1.20 0.22 0.1841 1.45 7.60 5.2414
2/2/2015 1.19 32.23 -0.55 -0.23 0.4226 -1.47 -9.82 6.6803
26/6/2015 1.77 38.89 0.49 0.21 0.4240 0.58 6.66 11.4828
29/8/2016 0.76 30.25 -0.57 -0.22 0.3893 -1.01 -8.64 8.5545
12/12/2016 1.34 35.16 0.76 0.16 0.2127 0.58 4.91 8.4655
4/12/2018 0.11 29.60 -0.92 -0.16 0.1723 -1.23 -5.56 4.5203
24/6/2019 0.30 28.82 1.73 -0.03 -0.0153 0.19 -0.78 -4.1053
14/8/2019 0.01 25.88 -0.97 -0.10 0.1055 -0.29 -2.94 10.1379