And by many measures, the demand for longer term fixed income assets is increasing, not decreasing. If we were to postulate that both parts of the yield curve might invert — i.e. the 2 year yield may be higher than the 10 year and the 10 year in turn may be higher than 30 year — there will be a lot of damage to investors in all asset classes, not just bonds.
The main reason is that “carry”, or “maturity transformation” as it is known in more refined circles, is the foundation of a levered economy. “Borrow short, lend long”, works as long as the yield curve is positively sloped. Once it inverts, the cost of financing exceeds the return on investment, and it becomes impractical to be involved in the yield curve carry trade, or many other carry trades that are driven by cheap short term financing.
The risk-premium in the yield curve is a fundamental driver of risk premium in almost all other markets. There are deep relationships between the yield curve carry trade and the carry earned from selling volatility (i.e. selling options). This extends even to the carry one earns from buying corporate bonds instead of risk-free assets, and to the carry earned by investing across countries (i.e. the currency carry trade). In short, carry leaks out from one market into another, and in this way markets can get exposed to the same set of macro shocks. No wonder that financial market breakage is countered by a rapid ease in the short term rate, flooding the market with liquidity, and an ensuing steepening of the yield curve. But short rates today are very low, and the Fed is telegraphing a withdrawal of liquidity, both in action and in communication.
But here is the catch. Even if we believe that the yield curves will invert and the possible consequences will be large, the cost of putting on the inversion trade directly today is one reason this is not a “slam-dunk”. For example, by looking at the forward curves, we can compute that one year ahead the market is pricing in a reduction of the 2 year vs. 10 year spread which is almost 0.40% lower than the current spread. A lot of flattening is thus already “baked in”. So an investor who decides to do the inversion trade today is again, in the language of options, effectively paying a “premium” of 40 basis points to do this trade. This is a high hurdle for anyone looking for carry, and very few are willing to lock in negative carry in order to express a view on the direction of the yield curve. Given the lack of other opportunities for earning yield, this is a costly premium indeed.
But like beauty, the price of an asymmetric position is in the eye of the beholder. The question for investors is whether the ensuing capitulation could be large enough that this asymmetric position would be well worth the cost. While the negative carry from doing the inversion trade itself might be costly, it is still attractive today to look for other, cheaper sources of convex, asymmetric investments that are likely to do well if yield curves invert and markets suffer the breakage that they almost always do when this happens.
Positioning For The Coming Capitulation, Forbes
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, an SEC registered investment adviser and a CFTC registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.