One of the most surprising moves of 2014 has been the flattening of the Treasury yield curve. Now with expectations for continued flattening will the curve surprise with steepening?
Coming into 2014 economic optimism was strong, enough so that the Fed had just begun the tapering process, and markets started to price in higher rates. The optimism cooled quickly as a “polar vortex” brought extreme cold across much of the United States limiting economic growth. GDP for the Q1 came in at -2.0% and is has taken the rest of the year to recover. Coming into 2015, optimism is starting to build again but the markets and the Fed are being a more cautious about moving too fast.
The fiver-year/30-year Treasury spread started the year at 220 and has seen a steady flattening, and it is now flirting with 100; a level not seen since great recession levels of 2008.
Strengthening economic data the last month with help from lower energy costs has markets increasing their expectations for Fed tightening by pushing the short end of the Treasury curve lower. The long end of the Treasury curve has remained stubbornly bid, expectations that the tightening process will be fairly slow and continued global safe haven (owning dollar assets) buying. Looking that the individual five-year (FVH5) and 30-year (USH5) contracts (see charts below), it is easy to see the flattening that has taken place since mid-November. The USH5 contract has held a steady trend higher to new highs with shallow retracements while the FVH5 has struggled to follow and is in the process of retesting support at the lows of the last two months. Looking forward, the last revision for Q3 GDP came in hot at 5% and expectations for the first Fed tightening have moved up to June; if the data continues to be strong the pace of Fed tightening will also increase. If that happens the long end of the curve will start to react and we could see the Treasury curve steepen, if economic growth slows from here the flattening should continue.
Treasury futures and options volumes provide deep liquidly making them a great vehicle for trading the yield curve. Using futures also allows for flexibility in creating a trade. Current duration weighting for the 5-year/30-year Treasury spread is 3.1 FVH5 vs 1 USH5, most are using 3 to 1 to keep it simple. The flexibility comes in being able to adjust weightings intraday depending on market direction views. For options weighting the deltas works well.