Long-end Yields Set to Decline, Flatten Curve

Summary

The U.S. 5-year 30-year spread is poised to flatten with investor positioning reaching steepening extremes and the Federal Reserve committed to normalizing policy.

Comment

The chart below shows rolling one-month flows for U.S. Treasury and investment grade corporate ETFs by duration bucket.

Increasing volatility across risk assets is causing investors to deleverage portfolios and send flows to cash and cash-equivalents. Durations above three years are being sold at a rate not seen since the taper tantrum. Conversely, durations between zero and two years (red bars) are gaining more and more assets.

The chart below compares yield curve positioning by investors in ETFs to futures contracts.

ETF positioning = Rolling three-month ETF flows for durations inside 2 years minus 6-to-10 years (duration weighted-spread).
Futures positioning = Total net positioning as a percentage of open interest for eurodollars minus 10-years

Higher, positive values indicate positioning for steepening, while lower, negative values indicate positioning for flattening.

Investors via ETFs are seldom in agreement with futures over the path of the yield curve. Well, until now. ETFs and futures positioning are heavily biased toward a steepening yield curve.

The U.S. 5-year 30-year spread’s nearly 20 bps of steepening in October 2018 has come by way of rising real yields, not a larger inflation premium. Unfortunately, global economic data changes are slowing with only 41% of major economies producing above average growth. For this reason our fair value estimate for the U.S. 30-year bond yield resides lower in the trading range dominating most of 2018 at 3.07%. All in all, the long-end is likely to rally in the weeks to come.

Our fair value estimate for the U.S. 5-year 30-year spread is much flatter at 15.7 bps. The U.S. 5-year note remains the punching bag of the curve when it comes to shifting FOMC rate hike timing. But, a Federal Reserve hell-bent on normalizing policy should keep U.S. 5-year yields from descending too far.

The last chart shows the rolling 25-speech frequency of ‘uncertainty’ words found within official Federal Reserve communications. Officials have seldom been this certain about the strength of the economy and path of short-term rates. We need to see rising concern and uncertainty to believe Powell et al will shift away from their hawkish bent.