Battered reflation trade in bonds faces more pain in Fed's wake

San Francisco

THE abrupt disintegration of the Treasury market's premier reflation trade may not be done, after bets that the economic revival would drive up long-term yields unravelled at a speed last seen a decade ago.

Last week's hawkish pivot by the Federal Reserve ran into a market that was as short as any point in the past 16 years. The result was a mad scramble to unwind so-called curve steepeners. The position had dominated the narrative for months as investors absorbed the central bank's signals that it was willing to let inflation run hot as growth rebounded.

But now the Fed appears more ready to fight rising inflation with rate hikes, and officials are also starting to discuss tapering their massive bond-buying programme. The upshot is that the pain may not be over for those still in steepener wagers, with traders bringing forward bets on when the central bank will lift rates, to late 2022. Stocks slumped as some investors positioned for a diminished outlook for strong economic growth.

"Structurally, the steepener may have run its course this year," said Patrick Leary, chief market strategist and senior trader at Incapital in Chicago. "There might still be some opportunity for some back-and-forth action between steepeners and flatteners, but the 5s30s curve has completely broken out of any technical areas that we've seen in a while," which means flattening could continue.

Ordinarily, the steepener is seen as an expression of a brighter economic outlook, which the Fed delivered as policymakers began to pencil in two rate hikes for 2023 and inched towards a greater likelihood of lift-off from near zero next year. But the Fed's latest forecasts also showed some officials see a risk that higher inflation will be somewhat persistent, rather than being transitory.

Comments from Fed official James Bullard on Friday added fuel to the flattening move. Short-maturity rates surged after he said he backed a late-2022 lift-off. He also said officials had begun discussing tapering asset purchases, which is seen as a prelude to rate hikes.

Most traders are leaning towards a stronger signal on tapering coming in August at the Fed's annual retreat in Wyoming, with an actual announcement later in 2021.

Traders who watch charts to gauge what's next noted that the 5- to 30-year spread dropped below its 200-daily moving average on Wednesday for the first time since March 2020. It touched 111 basis points on Friday, its lowest since September, and collapsed roughly a quarter-percentage point last week, the most since 2011.

Russ Certo, managing director of rates for Brean Capital, said the spread could flatten to 105 basis points, a level last seen in August, even if that's not his base-case scenario for the next few days. Citigroup strategist William O'Donnell sees scope for a bigger retrenchment.

There are strong indications that "a new long-term flattening phase has begun", reversing a steepening phase in place since July 2018, according to Mr O'Donnell.

Friday's close below 114 basis points removes key near-term support - leaving 94 as the next important level to watch, he said. That would be its flattest since July of last year.

This week brings the potential for more turbulence, with appearances by Fed chairman Jerome Powell and numerous regional Fed presidents. The outlook for the Fed's asset purchases is a topic at the Tuesday congressional hearing where Mr Powell will speak virtually.

Some traders are already prepping for further swings. This past week saw a large buyer, to the tune of US$14 million in premium, of an options position targeting increased volatility over the next month.

At Incapital, Mr Leary says his firm was neutral on both steepeners and flatteners before the Fed meeting, with the view that either one could play out. Incapital stayed neutral even after the Fed's latest decision, he says.

"We were caught off guard by the flattening moves in recent days, but are less inclined to jump on board," he said. Still, "if I get an opportunity, it's a trade I want to look at and consider going forward - because there are probably better entry points". BLOOMBERG