"Fed-proof" trade sounds just lovely ..... but it's not to be confused with "fail

Tuesday 24th October 2017

ref :- "Bond Traders Are Piling Into a Fed-Proof Bet" , Bloomberg Markets

Vying for the position of the biggest question hanging over markets at the moment (probably neck-and-neck with the pace of the ECB's QE tapering, expected to be announced on Thursday) is the identity of the next Fed Chairman, and his or her likely monetary policy. President Trump is expected to announce his appointment by the end of next week (though it could be sooner) and a reminder of the leading runners and riders might be in order :

Janet Yellen : the current Chair of course, who got a fearful shellacking from Donald Trump in his campaign rhetoric for easy monetary policies but although viewed as being on the doveish side is predicting a more aggressive course of rate rises than the market considers likely.

Jerome Powell : current Fed Board Governor of similar views to Janet Yellen who would also represent continuity but with the added benefit (as far as Mr Trump is concerned) of not actually being Janet Yellen.

John Taylor : Stanford University economist and architect of the "Taylor Rule" for central bankers, which advocates a strict adherence to guidelines of where interest should be given levels of GDP growth. Consequently, most would see his appointment as something of a hawkish move.

Kevin Warsh : A former Fed governor with both ticks and question marks against his name from his time serving under Ben Bernanke. Factors in his favour are not being a formal economist (which might appeal to DT) , his support of financial deregulation (which certainly will), and close family connections through his in-laws with the Trump family (need you ask ?). Would be seen as a hawkish appointment.

The Bloomberg article highlights how some of the biggest bond dealers are putting on trades that they believe will succeed WHOEVER gets the nod -- trades that profit from a flattening of the yield curve.

*** For newcomers, a very basic example of a curve-flattening trade : in normal circumstances and as you would expect, lending money for longer demands a higher rate of interest. This would be represented on a graph as an upward-sloping line from left to right as yields get higher as the time period gets longer. If yields at the short end rise quicker than those at the long end (or fall more slowly), the line -- or yield curve -- flattens. Since bond yields move inversely to bond prices, the very simplest way to gain from such a flattening would be to SELL the shorter-dated securities and BUY the longer-dated ones, in the expectation that difference in yield will narrow. Even assuming both ends of the trade move in the same direction, a flattening of the curve would mean that the profit on your sale would exceed your loss on your purchase. It's not impossible that shorter yields could rise at the same time as long yields fall -- in which case you would make money on both sides of the spread. ***

The flattening of the yield curve has already gone an awful long way. Since mid-December when the Fed raised rates for the second time since the recession, the spread between the yield on the 2yr Treasury and the 10yr Treasury has narrowed from 135 basis points (bp) to just 80 bp. The 2yr / 30yr spread has narrowed from 202 bp to 132 bp. These are big moves, and largely responsible is a surge in the 2yr yield. In 2016, the Fed had announced its intention to hike rates four times but in the event was able to raise just once, hampered by some stuttering data at home and worrying economic wobbles abroad. The market had plainly envisaged a similar scenario for 2017, but it's heavily odds-on that rates will be hiked for the third time in December.The market has had to scramble for cover as expectations have altered, and since the 2yr Treasury is more responsive to hikes in short-term rates than its longer-term equivalents, it's 2yr yields that have spiked -- to the highest rate since 2008, in fact (1.58%).

The rationale behind backing further flattening of the yield curve is that the path to so-called "rate normalization" -- higher rates and therefore higher yields at the short end -- will continue WHOEVER gets given the top job by President Bush. Even Janet Yellen, considered the most doveish of the group, hasn't acted or sounded much like a dove of late. She's predicting four rate hikes in 2018 whilst the market has priced in just two -- and 2017 has proved that the market can underestimate these things. At the same time, because the long end of bond markets are so sensitive to inflation (because it eats into future FIXED interest payments) but less vulnerable to changes in short-term rates, the LACK of any significant inflation concerns will mean that longer yields will be more subdued -- comparatively speaking. All in all, that's curve flattening.

John Herrmann of MUFG Securities Americas, whose been having a pretty good run predicting curve flattening throughout 2017, is not about to stop now. He reckons that if either of the "more doveish", continuity candidates get appointed, Janet Yellen or Jerome Powell, the 2yr/10yr spread (now at 80 bp) will narrow to 41 bp by end 2019. If either of the more hawkish John Taylor or Kevin Warsh are successful, expect zero bp or even a negative spread by the same date.

Seems like a no-brainer when looked at like that, doesn't it ? But nothing's that certain .... remember an awful lot of people are positioned that way already which could make things especially painful if one has to scramble out of the trade in a hurry for any reason. And last week may have given us an inkling of what could, just possibly, go wrong. The curve, mildly and briefly, actually steepened after the Senate narrowly approved a budget vehicle for tax cuts, currently Mr Trump's top legislative priority. If the administration manages to get the proposals into law, long end yields could rise more sharply than shorter ones (and long end prices fall further) on the expectation that the cuts would foster stronger growth and therefore inflation.

As we've said many times, there's no such thing as a sure thing.

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