Since 10-year treasuries broke through the 3% barrier earlier in 2018, there has been disagreement over how interest rates will move next. Danielle Myles analyses what the yield curve signals for investors and corporates, and how they can protect their portfolios and balance sheets.

Jerome Sabah

Jerome Sabah

Two years is a long time in the world of US interest rates trading. Back in mid-2016, the federal funds rate had nudged up to 0.25%, but the hunt for yield remained all-consuming for investors needing to satisfy return obligations to their end clients. Fast-forward to today, and the US Federal Reserve (the Fed) is in a rate hike cycle, while yields on the benchmark 10-year treasury note have broken through the 3% barrier – often viewed as signalling the end of the bull bond market – no fewer than five times since late April.

This has created a new paradigm for interest rates trading. “We have moved from a low-rate environment and low volatility, which triggered yield enhancement strategies and appetite for more risky assets, to a world of rising yields, which means a bigger focus on asset valuations and on hedging strategies,” says Jérôme Sabah, global head of rates, credit and foreign exchange sales for financial institutions at Société Générale Corporate & Investment Banking (SG CIB). To fully assess the ramifications for trading, however, it is first necessary to identify what has caused yields to increase, as well as their interaction with the equity markets.

Trading a historical anomaly

Treasury yields started to rise in earnest in February, largely due to inflation fears. Unfortunately for investors, this coincided with the US equity volatility index, VIX, hitting a six-and-a-half-year high and the S&P 500 and Dow Jones dropping. This positive correlation between equity and bond prices is relatively unusual, and it sparked concern among investors about how to protect asset value.

“If you are a portfolio manager and you are long-equity, generally if equity is selling off then your long bond positions should perform,” says Mr Sabah. “But when inflation is back on the table, yields go up and equity heads down.”

The buy-side has found ways to defend portfolios against a further increase in correlation between fixed income and equity. “Investors are looking at an S&P 500 put which is dependent on rates going higher, or a call based on lower rates. They can also do a payer swaption which is contingent on S&P going lower,” says Michael Pintar, SG CIB’s head of fixed income and currencies flow strategy and solutions for the Americas. “These types of trades play on the correlation of equities and fixed income to cheapen up the overall hedge, as there are two variables rather than just one.”

In recent months, it has become clear that factors other than inflation are behind the spike in treasury yields. Alongside its continued normalisation of rates, the Fed has stepped up efforts to unwind its balance sheet by not reinvesting funds from maturing assets. In addition, the Treasury must raise debt to finance the government’s $1000bn tax reform and record budget deficit. Meanwhile, the reduction of corporate tax rates is tipped to prompt US tech giants to repatriate their overseas cash piles. Many had been investing these funds in bonds.

Taken together, these factors suggest that the expectation of greater supply and lower demand for treasuries is what is now driving higher yields. Indeed, 10-year treasuries continued to rise in mid-May, despite weaker-than-expected inflation figures being published the week prior.

Boom and bust?

There has also been significant movement at the short end of the curve, with two-year treasuries rising alongside the federal funds rate. The yield curve flattened for much of 2017, and some queried whether this might signal the beginning of an economic downturn.

According to Jean-François Robin, Natixis’s head of global market research, it is too early to talk about recession expectations within the yield curve. “The main reason why the curve is flattening and yields are going up is because the Fed is normalising its monetary policy,” he says. “I think there is some confusion out there in the market, but so long as it’s a ‘bear flattening’, this is an ordinary effect of the Fed normalising rates.” Bear flattening, in this context, is when all rates are rising, but short-term rates rise faster than long-term rates. This is in contrast to bull flattening, when all rates are falling but long-term rates faster than short-term rates.

This distinction is critical when using the yield curve to forecast economic growth. It is also important to note that while recessions are invariably preceded by a flattening or inverting curve, these shifts are not always followed by a downturn. Earlier in 2018 the spread between the two-year and 10-year treasuries shrank to its narrowest since 2007, which revived questions about whether the US is heading into recession territory. To Mr Robin, the answer is simple: “I think probably not. This is just a case of the US economy approaching a deceleration in growth, which is usual when you are nearly at full employment.”

The main reason why the curve is flattening and yields are going up is because the Fed is normalising its monetary policy

Jean-François Robin

A genuine market

US economic growth aside, there is still genuine debate about how rates will move next. “We are at a really interesting moment when have a real market between people who think rates will keep going higher and those thinking now is a good time to make a play on declining yields,” says Mr Robin. Indeed, while discussion has so far centred on rising yields, the forward curve for the overnight index swap rate inverted in April, suggesting the Fed will start cutting rates from 2020.

There is a good reason for the lack of consensus. Never before has the US experienced short-term rate rises at the same time as the Fed unwinds its balance sheet and the Treasury unleashes a wave of bond sales. This unprecedented mix of supply, demand and policy rate changes makes it hard to forecast shifts in the yield curve.

The volatility that accompanies this uncertainty has prompted more corporates and investors to consider derivatives for the first time. “Every additional psychological marker, including 2% and now 3%, brings new entrants into the market for hedging rates volatility,” says Mr Pintar. “I think a lot of it has to do with the ranges. When yields move in a range you tend to get less hedging, but as we break through into this new regime, there’ll be more and more participants.”

Popular trades

Investors have multiple ways to protect their portfolios – or benefit – from the changes they expect in yields. To date, rising rates have prompted many to focus on high-quality, short-dated securities. “A large majority of our clients worldwide have kept short-duration strategies because, inter alia, of the Fed shrinking its balance sheet and the US’s record budget deficit financing,” says Mr Sabah. “They thought the issuance story in the US would fuel higher yields, and that is what we now see happening.”

Mizuho’s head of European rates strategy, Peter Chatwell, highlights another strategy to defend bond portfolios. “A protection trade for those who are long fixed income, but are fearing that we are moving to a more aggressive rate hiking cycle, would be to look at swaps spreads,” he says. This means taking a view on the changing spread between an interest rate swap and treasury note with the same maturity.

A popular trade since mid-2018, which focuses on the shape of the curve, is shorting short-term treasuries and buying long-term notes. This so-called ‘curve flattener’ allowed investors to generate returns as the curve flattened. But this strategy may soon fall out of favour. “We think there is a regime change taking place on the US curve, which will see a move towards a curve steepening environment,” says Mr Chatwell. “That would mean that investors who profited from the flat curve may be looking to reverse that now by buying the short rate and selling the long rate.”

Indeed, traders and analysts at some US banks expect 10-year yields to hit 3.25% – or even 3.5% – by the end of 2018. Some speculators are already wagering that the curve will steepen. Real money investors, particularly pension funds, are looking at yield curve caps to protect their investments from such a change. “This plays on the fact the yield curve is approaching inverted levels on a forward basis, which is a historical anomaly,” says Mr Pintar. “As the yield curve steepens, long-term rates are generally going higher, so this trade acts as a hedge to some static long positions they have in fixed income in their portfolio.”

The inverted forward curve can be traded in other ways, too. “In absolute terms, forward volatility on rates such as 15-year/15-year is pretty cheap,” says Mr Sabah. “[This] has triggered more opportunities in terms of hedging strategies among pension funds and life insurance companies through swaps or swaptions.” He believes these are among the best trades in the current environment because they make it possible to be long volatility, but with a positive carry.

According to Mr Robin, at this point in the cycle investors should be covering themselves from the tail risk of the market. “It seems unlikely that the Fed will hike to 3%, and treasury notes probably won’t break above 4%,” he says. “On the other hand, the 1.5% lows for 10-year notes seen during the crisis are likely to remain an exceptional event. So using options to play yields ranging between 1.5% and 4% could be worth considering.” For example, selling options with a strike price of a 4% federal funds rate can protect an investor from extreme market moves.

Treasurers’ dilemma

In protecting their balance sheets, corporate borrowers are facing a different set of considerations. In the years immediately following the global financial crisis, when interest rates plummeted, many US treasurers locked in low borrowing costs by fixing up to two-thirds of their notes, a significantly higher proportion than conventional financial theory supports.

It is still possible for corporates to hedge their debt and interest rate swaps, whose spreads over treasuries are normalising. But as the Fed is well into a rate-hike cycle, bankers say it has become difficult to put a lot of money in rising rates. There are other reasons why derivatives are not necessarily the best way to reduce rates risk. “Terming out bank debt with an interest rate swap fixes the rate but it doesn’t give you secured funding as you are just hedging the interest rate risk of your floating rate debt,” says Tom Deas, chairman of the US National Association of Corporate Treasurers. “The double risk reduction, which removes both the rate risk and funding risk, is to issue a fixed-rate bond.”

In addition, at this point in the yield cycle hedging long-term risk via swaps does not make sense mathematically. “Although 10-year treasury rates have gone up about 1.4%, corporate bond rates since mid-July 2016 actually haven’t gone up that much. They’ve moved in a band which means the volatility of coupon rates has been pretty low,” says Mr Deas. Indeed, the 10-year high-grade corporate rate has increased less than 1% since its all-time low of just under 3% in July 2016.  

The shape of the corporate yield curve provides more reasons to hold off on long-term hedges. While the short to medium end of the curve is relatively steep, the yield differential between two- and 10-year notes is about 1%, which suggests people do not expect rates to rise aggressively in the long term. “To hedge for 10 years, you need to more than double your coupon rate from 1.7% for overnight commercial paper to 4% for a 10-year bond,” says Mr Deas. “For a treasurer, that’s a hard message to take to your chief financial officer or chairman. To say we should buy an insurance policy that will reduce our income to hedge against a risk that is not very convincing.”

One strategy that bankers expect to pick up is rate-locking. This sees corporates that have decided to sell a bond setting a fixed coupon with their potential dealers a few weeks before launching the deal. This protects them from any rate rises immediately preceding the issuance.

Across the Atlantic

Investors and corporates exposed to rates on the other side of the Atlantic face a different set of circumstances, as revealed by the spread between 10-year treasuries and 10-year bunds (the eurozone benchmark) recently hitting a multi-decade high.

The European Central Bank has recently laid out plans to wind down its bond-buying programme, expected to commence later in 2018. While inflation in the eurozone hit 1.9% in May, figures for the previous months were weaker than expected. That led the market to start pricing in rates normalisation starting 2020, rather than early 2019 as they had done previously.

The house view of many banks, including Mizuho, is for eurozone rates to remain benign. “There is still evidence that we are in a liquidity trap, and it will be very difficult for the European Central Bank to put rates up even as quickly as is priced into the forwards,” says Mr Chatwell. Investors and borrowers appear to empathise with their view – and are in no rush to protect themselves.


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