Complex Made Simple

Making money in the US Treasury bond yield curve panic

The bloodbath in global equities markets in May and the spike in the Chicago Volatility Index (VIX) to 19 all mean to buy the long T-bond futures

An embryonic global financial panic in risk assets can only be averted with an emergency 50 basis point rate cut this summer by the Federal Reserve Lord Rothschild said the best time to buy was when “blood ran in the streets”, as it does now in any segment of Wall Street correlated to bond yields or the US Treasury bond yield curve Leveraged, closed end mortgage bond funds now offer fabulous dividend yields at dirt cheap prices and lovely net asset value (Yo mortgage REIT’s!) discounts

By Matein Khalid: Chief Investment Officer and Partner at Asas Capital

The 100 basis point plunge in the ten year US Treasury note, 2.14% as I write, since last October is downright scary. Of course, Trump’s latest Mexican tariff salvo is the catalyst for the latest “safe haven” bid in Uncle Sam debt, but the fact remains that weak global economic data, muted inflation pressures, a trade war with China and free falls in crude oil/emerging markets currencies have all contributed to the inverted US Treasury bond yield curve – and a shocking minus 20 basis point yield in the ten year German Bund, the latest reason to short Deutsche Bank. The bloodbath in global equities markets in May and the spike in the Chicago Volatility Index (VIX) to 19 all mean the macro trade de jour is to buy the long T-bond futures contract on the CBOT futures pits in Chicago’s La Salle Street. The two-year T-note yield has plummeted to 1.90%, 35 basis points down in May, the most since November 2008. This is raw panic, the bond market crying out for Mommy Jay Powell! 

The message from the Treasury bond market is crystal clear. A protracted trade war with China and now Mexico alarmingly raises the risks of a global recession. This message places the Powell Fed in an acute policy dilemma. A verbal monetary policy U-turn, as witnessed in the December and January FOMC conclaves, is no longer enough. Chairman Powell now faces an embryonic global financial panic in risk assets that can only be averted with an emergency 50 basis point rate cut this summer. This is now the consensus view implied by the Fed Funds/Eurodollar futures contracts in the Chicago Merc.

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It is ironic that the US economic supertanker has not hit any macro iceberg despite the deflation SOS implied by the plunge in global bond yields. GDP growth in Q1 2019 was a stellar 3.1%. Consumer confidence, house prices and the labour market are all white hot. US money centre banks, recapitalized, derisked and stress tested galore, are the safest, best managed, most profitable financial institutions on earth. Are the yield curve Cassandras predicting a US recession that will not happen? In my view, absolutely yes.

The impact of the US Treasury bond yield curve as an advance indicator of real economic performance has declined dramatically since Reagan’s second term in the late 1980s. This was the era of Black Monday, the success of Chairman Volcker’s epic anti-inflation crusade, the savings and loan crisis, the LBO/high yield bond/Drexel Burnham debacle and the first Fed/Saudi bailout of Citigroup in 1991. Once the financial markets were convinced that the Volcker – Greenspan Fed had successfully executed inflation targeting, every uptick in the Fed Funds rate to combat inflation data noise could be dismissed as transient. Long term bond yields could then continue to decline. An inverted yield curve did not necessarily mean recession, even though it preceded the recessions of 2001 and 2008-9.

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However, all the academic models I imbibed on the term structure of interest rates at Wharton became obsolete after the Bernanke Fed began its $3.5 trillion quantitative easing program in the depths of the global financial crisis. As the central banks of creditor nations like China, Japan, Taiwan, Saudi Arabia, Switzerland and UAE scramble to buy a scarce pool (and flow) of long duration US Treasury bonds, it became impossible to predict economic cycles via the term structure of interest rates alone. Sad but true.

Lord Rothschild said the best time to buy was when “blood ran in the streets”, as it does now in any segment of Wall Street correlated to bond yields or the US Treasury bond yield curve. Money centre banks have been slammed by the flattening of the yield curve all summer. J.P. Morgan is now 105, Citigroup is 61 (though Banamex revenue growth will take a hit if Trump puts the mantequillas on the Texas/Arizona border out of business with his tariff magic wands). True, a full-blown risk spasm (Volatility Index at 35) means Citi could fall to 54 – 56 and the House of Morgan to 94 – 96 yet I can now project a risk-reward calculus I seek in the options market. Leveraged, closed-end mortgage bond funds now offer fabulous dividend yields at dirt cheap prices and lovely net asset value (Yo mortgage REIT’s!) discounts.

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There is no doubt in my mind that I can design 9 – 12% US dollar yield ideas that will get a high-octane price boost when the Powell Fed finally cuts rates. So, please Chairman Powell, do not soil your legacy by being a central banking Nero who fiddles while Rome (the hyper-volatile, networked, daisy chains of world finance) burnt. So Tweeter-in-Chief did not take you to have lunch with the queen at Buck House and bullied you rotten. Yet he has check-mated you with his Mexico tweet. So do the right thing. A 50 basis point cut in the Fed Funds rate at the July FOMC. Do it. Do it now!