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Enough is enough. That's the message hedge funds are seeing when they look at this chart...
The ridiculously wide inversion/spread between the 3 month and 10 year maturities of the US yield curve has gone too far.
Reuters' Jamie McGeever noticed some positioning moves suggesting that the game is up - funds are now betting on curve steepeners to unwind the inversion...
Quick caveat. Positioning in bond and stock futures isn't always as relevant as it can be in FX markets. Futures are often used for hedging and more complex trade structures.
In the current context of the imminent Fed pause though, these positioning moves may well be indicative of the yield curve change that usually precedes recession and the turn in the cycle...
We talked about these same dynamics referencing the 2s10s curve here 👇👇👇
If we look back through history, generally when the spread starts to revert, we enter recession.
Now what could start a steepening (increase of curve)?
If the Fed starts being a bit softer on interest rates or we approach the terminal rate!
This is why currently, there is so much chatter over inflation, whether it is peaking and where it could end up, since interest rates change to try to affect inflation.
The terminology is always a bit of a headf**k here. When we're talking about steepeners, it's a bet on an upward sloping yield curve. But we're coming from a point of inversion so first we need to flatten... 👇
Even though it's called a steepener trade, it's a bet on a flatter yield curve FIRST as short and long term rates begin to converge. The next step is for the curve to slope upward as markets anticipate rate cuts and/or the next economic expansion.
Whether it works out that way is another matter of course, but that's the bet. Even though the curve may revert towards a flatter shape first, this isn't a flattener trade.
A flattener is a bet on the yield curve flattening (and/or inverting) from the positive side. We've already done that one. Great visualisation here by James Eagle (up to March 2022) 👇
So, what would this signify?
The market has seen enough. The economic data is poor. The Fed's very near the end of the hiking cycle. As Jamie points out 👇
From an economic fundamental perspective, however, a steeper yield curve is unlikely to be driven by a higher 10-year yield, at least if the incoming U.S. economic data is any guide.
From a tactical perspective, however, it makes more sense. Traders may be taking some of the froth out of the tightening priced into the next few Fed meetings, and may also be thinking that the curve, like a stretched rubber band, must surely snap back.
It's not necessarily a precise prediction about the future (no trade should be), more of a relative bet. Asking 'what's the trade?' is unlikely to be met with a reply that betting on an even deeper inversion is the way to go...
The Fed's now in their pre-meeting blackout period. The pause chatter is ramping up. It's unlikely to be confirmed at the Feb meeting, but the path is clear.
Here's Wells Fargo's summary from their latest FOMC flashlight report 👇
However, inflation remains too high for the Fed's liking, and most FOMC members continue to state publicly that rates need to go higher to bring inflation back to the target of 2%. We look for the Committee to raise its target range for the federal funds rate by 25 bps at each of its meetings on February 1, March 22, and May 3.
If realized, the target range would end the tightening cycle at 5.00%-5.25% in early May.
Given recent signs of slowing economic growth, we readily acknowledge that rates may not rise quite as high as we envision.
But we believe that in order to bring inflation back to 2% on a sustained basis, the FOMC will maintain its target range at the terminal rate longer than most market participants currently expect. We do not expect the FOMC to begin cutting rates until early 2024.
The post-meeting statement already notes that policy will need to be "sufficiently restrictive to return inflation to 2 percent over time."
We can envision the Committee adding the phrase "for some time" to "sufficiently restrictive" in the February 1 statement. Chair Powell could also stress this intention in his post-meeting press conference.
All of which makes perfect sense. As does the steepener trade becoming relatively more appealing.
Historically, this is another tick in the things you see towards the end of the cycle column.
Corporate Profits are next on the chopping block 👇