The Daily Update - Belly Outperformance, Wings Motionless

An interesting day in the US Treasury market yesterday as the risk on trade gained traction with longer-dated bonds continuing their rally. In fact this morning we have an inversion of the yield curve from two years out to a five year maturity with the spread dropping through zero for the first time since 2007. Indeed the two year ten year spread also hit levels not seen for almost eleven years, trading below 14bp.

So what is driving this flattening of the curve? Donald Trump and his 90-day tariff truce has been mentioned, but surely this could prove to be a positive for economic growth. So agreed, credit should take heart but the Treasury market, can’t see it.

A clue maybe in the December 2018/December 2019 Eurodollar futures contracts spread, which is trading around 22bp and so pricing in a little under one further tightening of 25bp over the entire 12 months of next year. Of course, that is after the 19th Dec 2018 hike which is already priced in with a probability of a hike around an 80% certainty.

However, the UST curve has had an interesting time over the last two months. In early October we had 2-year yields at 2.82% and the long bond 30 year at 3.22%, the same as this morning for both rates. But the 5 year back then was at 2.96% and the 10 year at 3.07% while today the 5 year is at 2.81% and so 15bp lower and the 10 year is at 2.95% and so 12bp lower, a most impressive performance by the belly of the curve with the wings almost motionless.

Is the curve telling us the Fed tightening is almost complete with just two left for this cycle. So the 2 year is fairly priced while the belly of the curve is optimistic for maybe an easing within the next 2 plus years with moderate inflation. Whilst the long bond is reminding us the US budget position remains a problem with supply a continued risk.

Just ideas but worth further deliberation.

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