Bond Traders Are Taking Every Opportunity to Fade the Steepener

(Bloomberg) -- The U.S. yield curve’s torrid run toward inversion remains squarely on track as investors seemingly take advantage of any steepening to pile further into the flattener trade.

The spread between 2- and 10-year Treasury yields on Wednesday narrowed to the least since August 2007 as traders continue to crush a brief bout of steepening seen in the past month. Concern that Turkey-induced turmoil spreading across emerging markets could spark global contagion hasn’t derailed investors’ expectations that the Federal Reserve will keep tightening monetary policy, driving shorter-dated U.S. yields higher.

“When there are periods of steepening, that’s the environment where you are supposed to fade that and add to the flattener,” said Gene Tannuzzo, a money manager at Columbia Threadneedle Investments, which manages $495 billion in assets worldwide. Tannuzzo said that’s exactly what he’s done in recent weeks.

The yield gap between 2- and 10-year maturities had rebounded to just over 33 basis points both in late July and earlier this month before renewing its compression. The differential narrowed to as little as 23.4 basis points Wednesday, aided by a better-than-expected U.S. retail sales print, before ending the session at about 25 basis points.

Bond Traders Are Taking Every Opportunity to Fade the Steepener

“What we’ve realized in the last few days is that volatility in emerging markets is likely to continue for some time, but the U.S. data story has not changed so the Fed is not going to change its course,” Tannuzzo said. “The sustained steepening doesn’t come until the Fed changes its policy course, and we are not there yet.”

Policy makers, in the latest Summary of Economic Projections, signaled they expect to raise interest rates two more times this year and three times in 2019.

Large trades in interest-rate futures this week also show some derivative players using the recent steepening run to jump into or boost flattening wagers. Large block trades in Treasury note futures surfaced Monday and again Wednesday that are set to profit if the yield gaps between either 2- and 10-year or 2- and 7-year notes narrow.

The strong retail sales figures and other recent economic data suggest America’s economic expansion should remain robust in the third quarter, according to Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. He expects annualized growth of 3.5 percent in the July-September period, after the economy grew at a 4.1 percent clip in the second quarter, the fastest pace since 2014.

Donald Ellenberger, a senior portfolio manager at Federated Investors Inc., which manages about $380 billion in assets, says long-term yields will remain anchored despite Fed tightening as a result of the fading impact of fiscal stimulus and the potential growth headwinds brought on by a global trade war.

“The flattening trend is powerful,” said Ellenberger, who is also head of multisector strategies at the firm. Any trend reversals would “present a better opportunity -- at steeper levels -- to get into the long-term flattening trade.”

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