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Positioning in rates for signs of growth

| April 4, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Investors should consider putting on 5s30s Treasury curve flatteners, which are positive carry and likely to profit as the economy trends towards slower but solid growth over the next two quarters. The 5s30s slope is close to the high end of its 1-year range, and market conviction that the Fed will cut rates to defend growth is unlikely to erode. This will likely keep the 2-year note pinned below the Fed funds target, while an improving economic outlook should lift rates from the belly through the long end, flattening the curve.

Slower but steady growth

The US economy is migrating to a slower growth regime – a trend that has long been projected – but one that is far from the doom and gloom perspective currently reflected in the Treasury curve. Since late 2018 the rates market has gradually priced in an increasingly pessimistic scenario for economic growth, and more recently for a Fed that will respond to that weakness by easing monetary policy to defend growth. The next two quarters of 2019 should bring stability to the previous shut-down impacted economic data, reinforce the trend of moderate but stable GDP growth, and ease fears of a near-term recession. Amherst Pierpont Chief Economist Stephen Stanley projects 2019 GDP growth of 2.8% (Q4/Q4) versus market consensus of 2.1%.

No carry being long Treasuries

Being long Treasuries in the current environment requires stoicism. General collateral overnight repo rates remain elevated at 2.53%, thanks to some lingering distortion in the funding markets over quarter-end. That makes daily and 6-month projected carry flat to negative across the curve, with the exception of 30-year notes, which are positive on a dollar basis, but it barely amounts to a basis point once normalized for the increased duration risk (Exhibit 1).

Exhibit 1: Treasury carry and rolldown across the curve

Note: All carry and dollar value of a basis point (DV01) calculations assume $1 million face of the bond. An overnight general collateral repo rate of 2.53% is used for all bonds, which ignores special financing which can temporarily improve carry. The 6-month period ends 10/7/2019 which is 185 calendar days. All calculations as of 4/4/2019. Source: Bloomberg, Amherst Pierpont Securities.

Rolldown isn’t helping. The inversion in the front end means 2-year and 3-year notes are rolling up the curve, adding to the pain of being long. The modest projected rolldown in the 5- to 10-year securities is barely enough to offset the negative carry, and the 30-year sector of the curve remains so flat that over short time horizons it neither meaningfully hurts or helps long positions.

The fed funds target and the 30-year bond anchor the curve

Despite exhortations from the President, the FOMC seems broadly comfortable keeping the fed funds rate at its current 2.25 to 2.50% target range barring a meaningful and persistent shift in either inflation or unemployment. Lowering the target rate purely as a mechanism to defend growth lies outside the Congressionally established mandate of the Federal Reserve for the conduct of monetary policy. Doing so would seriously damage the Fed’s credibility as an independent body and potentially lead to the development of asset price bubbles. The market remains skeptical of the Fed’s resolve and the strength of the economy, pushing 2-year notes below the target rate in early March. History suggests this inversion will persist until the Fed does next cut rates, whether that cut is two months or 14 months into the future (Exhibit 2).

Exhibit 2: Inversion in fed funds vs 2-year Treasury prior to easing cycles

Source: Amherst Pierpont Securities

The 30-year bond yield is historically the least volatile point on the curve, and a low growth, low inflation environment will almost certainly reinforce that. The most volatile point on the curve has long been the 5-year Treasury, which is often said to lead the curve higher or lower – selling off the most when yields are rising, and conversely rallying the most when yields fall. The economic data over the next two quarters should be consistent with steady but slower growth and low inflation, pushing recession fears into the distance. The 5-year Treasury should lead rates modestly higher, flattening the long-end, while the inversion in the very front end of the curve remains sticky.

Treasury flatteners are positive carry

When the Treasury yield curve is flat to inverted, curve flattening trades can become positive carry and curve steepening trades conversely become negative carry (Exhibit 3). Overnight financing rates are currently hovering above the 2.50% target rate, thanks mostly to distortions over quarter-end that have yet to fully resolve. Assuming general collateral Treasury repo returns to the mid to high 2.40s these curve flatteners will remain positive carry.

Exhibit 3: Treasury curve flatteners

Note: General collateral repo of 2.53% used for all bonds, ignoring special repo rates for on-the-run Treasuries; 6-month carry to 10/7/2019 or 186 days. Flatteners are constructed duration-neutral. Source: Bloomberg, Amherst Pierpont Securities

The 5s30s slope is currently +60 bp, near the top of its 1-year range. The 5s30s flattener has a modestly positive carry of 3.7 bp over the next six months, giving the trade a breakeven spread of 63.7 bp. An easing of recession fears should flatten 5s30s back to the neighborhood of 40 bp, where it hovered for much of the fourth quarter of 2018, for a projected profit of 23.7 bp, or $11,031 per $1 million face of the 5-year.

A sell-off in the 5-year will pull the 2-year up with it, but it’s unlikely that 2s will develop enough momentum to break through the target rate. This will mechanically steepen 2s5s, but it’s a difficult trade to recommend given the negative carry and modest potential upside.

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