FOMC Showdown Poised to Ignite a Surge in Yield Spreads
With inflation finally cooling and the Fed signaling rate cuts, it seems relief is on the horizon—until you look at the job market. As recession risks grow and Treasury yields falter, a steepening yield curve presents a compelling opportunity.
Positioning in the yield curve ahead of the FOMC meeting offers a more measured way to navigate the uncertainty.
COOLING CPI SIGNALS GREEN LIGHT FOR RATE CUTS
This week’s inflation report showed headline CPI cooling to 2.5%, the lowest since February 2021. With this release, inflation has finally fallen decisively below the stubborn 3% mark and is now just 0.5% above the Fed’s target range. PCE inflation reflects similar levels, likely giving the Fed the signal to start cutting rates.
JOB MARKET REPRESENTS MATERIAL RECESSION RISKS
Recent job market data suggests it may be too soon to declare a soft landing. The labor market is significantly weakening, and with household savings dwindling and credit delinquencies increasing, conditions may worsen before improving.
U.S. economic data from the past week indicates that the labor market is in a precarious situation. The August JOLTS report showed job openings dropping to their lowest since early 2021, reflecting decreased labor demand, while unemployment edged up slightly.
Additionally, the August jobs report revealed a modest gain of 142,000 non-farm jobs, falling short of expectations, with downward revision for July bringing those figures down to just 89,000.
As covered by Mint Finance previously a recession is likely to lead to a sharp steepening of the yield curve.
We covered average levels of the yield spread at the start of recessions in detail previously, but in summary with the current 10Y-2Y spreads at 15 basis points, there may be up to 85 basis points of further upside in the spread.
TREASURY YIELD PERFORMANCE
Despite a short recovery following the ominous jobs report on 2/August, Treasury yields have continued to decline. Unsurprisingly, short-dated treasuries have underperformed as 2Y yields are 27 basis points lower, while 30Y yields have only declined by 12 basis points and 10Y by 15 basis points.
Overlaying yield performance with economic releases, the largest impact on yields over the last few months has been from FOMC releases and non-farm payrolls while performance around CPI releases has been mixed. Potentially suggesting traders are more concerned about recession risk than moderating inflation.
OUTLOOK FOR SEPTEMBER FOMC MEETING
FedWatch currently suggests that a 25 basis point rate cut is more likely in the upcoming FOMC meeting scheduled on September 17/18. However, probabilities of a 50 basis point rate cut are also relatively high at 43%.
While the odds of a 25 basis point cut have remained in majority, the 50 basis point cut has been uncertain with probability shifting over the past week.
FOMC meetings have driven a rally in yield spreads over the past year.
With FOMC meeting slated for next week, it is interesting to note that performance in yield spread prior to meetings has been more compelling than performance post-FOMC meeting. Over the last 5 meetings, pre-FOMC meetings, the 10Y-2Y spread has increased by 4 basis points.
Performance is even more compelling in the 30Y-2Y spread which has increased by an average of 13 basis points.
AUCTION DEMAND FAVORS 10Y
Recent auction for 10Y treasuries indicated strong demand with a bid/cover ratio of 2.64, which is higher than the average over the last 10 auctions of 2.45. Contrastingly, the 30Y auction was less positive with a bid/cover ratio of 2.38, below the average of 2.42. 2Y auction was sharply weaker with a bid/cover of 2.65 compared to average of 2.94.
Auction uptake suggests higher demand for 10Y treasuries than 30Y treasuries and fading demand for near-term 2Y treasuries.
HYPOTHETICAL TRADE SETUP
Recent economic data has made an upcoming rate cut nearly certain. However, the size of the cut remains unclear. CME FedWatch currently indicates a 42% probability of a larger 50-basis-point cut, driven by the recent CPI report and weak jobs data.
With rising recession risks, the Fed might opt for a larger rate cut. However, if they choose a moderate 25-basis-point cut, market sentiment could stabilize. Historically, yield spreads around FOMC meetings suggest that positioning before the meetings tends to be more advantageous than after. This is especially relevant now, as moderating sentiment from a 25-basis-point cut could trigger a temporary reversal in yield spreads.
Considering the underperformance of the 10Y-2Y spread in September and increased auction demand for 10-year Treasuries, a long position in the 10Y-2Y spread may be the most favorable strategy for gaining exposure to the steepening yield curve.
Investors can express views on the yield curve using CME Yield Futures through a long position in 10Y yield futures and a short position in 2Y yield futures.
CME Yield Futures are quoted directly in yield with a 1 basis point change representing USD 10 in one lot of Yield Future contract. This makes spread calculations trivial with a 1 basis point change in spread representing PnL of USD 10.
The individual margin requirements for 2Y and 10Y Yield futures are USD 330 and USD 320, respectively. However, with CME’s 50% margin offset for the spread, the required margin drops to USD 325 as of September 13, making this trade even more compelling.
A hypothetical trade setup offering a reward to risk ratio of 1.46x is provided below:
Entry: 14.2 basis points
Target: 35 basis points
Stop Loss: 0 basis point
Profit at Target: USD 208 (20.8 basis points x 10)
Loss at Stop: USD 142 (14.2 basis points x 10)
Reward to Risk: 1.46x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Positioning in the yield curve ahead of the FOMC meeting offers a more measured way to navigate the uncertainty.
COOLING CPI SIGNALS GREEN LIGHT FOR RATE CUTS
This week’s inflation report showed headline CPI cooling to 2.5%, the lowest since February 2021. With this release, inflation has finally fallen decisively below the stubborn 3% mark and is now just 0.5% above the Fed’s target range. PCE inflation reflects similar levels, likely giving the Fed the signal to start cutting rates.
JOB MARKET REPRESENTS MATERIAL RECESSION RISKS
Recent job market data suggests it may be too soon to declare a soft landing. The labor market is significantly weakening, and with household savings dwindling and credit delinquencies increasing, conditions may worsen before improving.
U.S. economic data from the past week indicates that the labor market is in a precarious situation. The August JOLTS report showed job openings dropping to their lowest since early 2021, reflecting decreased labor demand, while unemployment edged up slightly.
Additionally, the August jobs report revealed a modest gain of 142,000 non-farm jobs, falling short of expectations, with downward revision for July bringing those figures down to just 89,000.
As covered by Mint Finance previously a recession is likely to lead to a sharp steepening of the yield curve.
We covered average levels of the yield spread at the start of recessions in detail previously, but in summary with the current 10Y-2Y spreads at 15 basis points, there may be up to 85 basis points of further upside in the spread.
TREASURY YIELD PERFORMANCE
Despite a short recovery following the ominous jobs report on 2/August, Treasury yields have continued to decline. Unsurprisingly, short-dated treasuries have underperformed as 2Y yields are 27 basis points lower, while 30Y yields have only declined by 12 basis points and 10Y by 15 basis points.
Overlaying yield performance with economic releases, the largest impact on yields over the last few months has been from FOMC releases and non-farm payrolls while performance around CPI releases has been mixed. Potentially suggesting traders are more concerned about recession risk than moderating inflation.
OUTLOOK FOR SEPTEMBER FOMC MEETING
Source: CME FedWatch
FedWatch currently suggests that a 25 basis point rate cut is more likely in the upcoming FOMC meeting scheduled on September 17/18. However, probabilities of a 50 basis point rate cut are also relatively high at 43%.
Source: CME FedWatch
While the odds of a 25 basis point cut have remained in majority, the 50 basis point cut has been uncertain with probability shifting over the past week.
FOMC meetings have driven a rally in yield spreads over the past year.
With FOMC meeting slated for next week, it is interesting to note that performance in yield spread prior to meetings has been more compelling than performance post-FOMC meeting. Over the last 5 meetings, pre-FOMC meetings, the 10Y-2Y spread has increased by 4 basis points.
Performance is even more compelling in the 30Y-2Y spread which has increased by an average of 13 basis points.
AUCTION DEMAND FAVORS 10Y
Recent auction for 10Y treasuries indicated strong demand with a bid/cover ratio of 2.64, which is higher than the average over the last 10 auctions of 2.45. Contrastingly, the 30Y auction was less positive with a bid/cover ratio of 2.38, below the average of 2.42. 2Y auction was sharply weaker with a bid/cover of 2.65 compared to average of 2.94.
Auction uptake suggests higher demand for 10Y treasuries than 30Y treasuries and fading demand for near-term 2Y treasuries.
HYPOTHETICAL TRADE SETUP
Recent economic data has made an upcoming rate cut nearly certain. However, the size of the cut remains unclear. CME FedWatch currently indicates a 42% probability of a larger 50-basis-point cut, driven by the recent CPI report and weak jobs data.
With rising recession risks, the Fed might opt for a larger rate cut. However, if they choose a moderate 25-basis-point cut, market sentiment could stabilize. Historically, yield spreads around FOMC meetings suggest that positioning before the meetings tends to be more advantageous than after. This is especially relevant now, as moderating sentiment from a 25-basis-point cut could trigger a temporary reversal in yield spreads.
Considering the underperformance of the 10Y-2Y spread in September and increased auction demand for 10-year Treasuries, a long position in the 10Y-2Y spread may be the most favorable strategy for gaining exposure to the steepening yield curve.
Investors can express views on the yield curve using CME Yield Futures through a long position in 10Y yield futures and a short position in 2Y yield futures.
CME Yield Futures are quoted directly in yield with a 1 basis point change representing USD 10 in one lot of Yield Future contract. This makes spread calculations trivial with a 1 basis point change in spread representing PnL of USD 10.
The individual margin requirements for 2Y and 10Y Yield futures are USD 330 and USD 320, respectively. However, with CME’s 50% margin offset for the spread, the required margin drops to USD 325 as of September 13, making this trade even more compelling.
A hypothetical trade setup offering a reward to risk ratio of 1.46x is provided below:
Entry: 14.2 basis points
Target: 35 basis points
Stop Loss: 0 basis point
Profit at Target: USD 208 (20.8 basis points x 10)
Loss at Stop: USD 142 (14.2 basis points x 10)
Reward to Risk: 1.46x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Full Disclaimer - linktr.ee/mintfinance
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