Yield Curve Reinverts on Easing Rate Cut Expectations
Fed sets the rates. Rates guide treasury yields. Fed remains data dependent. Incoming data creates nuanced shifts in yield spreads.
The September jobs report revealed 254,000 jobs added, significantly exceeding expectations of 147,000, with August figures also revised upward. This strong report, along with the JOLTS data from earlier in the week, indicates that the job market remains strong and not as weak as previously anticipated.
Despite the strong jobs data, the yield curve has inverted once again. While Mint Finance has previously highlighted that recession risks can lead to the yield curve inverting, that is not the only reason. This time around, the inversion is being driven by delay in rate cut expectations. CME’s Yield Futures enables investors to deftly express their views on the path of rates ahead.
JOB MARKET SHOWS MIXED SIGNS OF RECOVERY
The latest JOLTS figures showed U.S. job openings rising from 7.711 million to 8.090 million in August, with the previous month's numbers revised up by 38,000. Although job openings remain near a two-year low, the increase is a positive sign.
Rise in job openings was primarily due to increase in construction jobs (+138k), which are often seasonal, and government jobs (+103k). However, the overall report paints a mixed picture. Hiring fell by 99k from the previous month, and while total separations dropped by 317,000, the largest contributor was a 159,000 contraction in quits.
With fewer hires and a large drop in quits, the data suggests the job market is not particularly strong, as workers hesitate to leave their current positions with fewer being hired into new roles.
The Non-Farm Payrolls (NFP) showed 254,000 jobs added in September, with health care, social assistance, and leisure and hospitality sectors leading the gains. As a result of these additions, the unemployment rate eased to 4.1%. Hourly earnings grew by 4% YoY, with the previous month's figures revised upward to 3.9%.
RATE CUT EXPECTATIONS TEMPER
Further rate cuts are still expected, but the anticipated pace has slowed. Before the PCE inflation report on September 27, CME FedWatch indicated a cumulative 75 basis point reduction over the next two FOMC meetings in November and December.
CME FedWatch tool also indicated a high probability of 100 basis-point cuts last month. However, after the encouraging PCE report, which showed inflation easing to 2.2%—its lowest level since 2021 and close to the Fed's target—the probability of a cumulative 50 basis-point cut has steadily risen.
Following the jobs report last week, the probability of cumulative 50 basis-points cuts surged to 80%.
The trend suggests that market participants are increasingly expecting a soft landing, with inflation easing and the job market remaining strong. A soft landing reduces the urgency for aggressive rate cuts, giving the Fed more flexibility to monitor the effects of previous rate hikes and lower rates more gradually.
Crucially, Fed Chair Jerome Powell has suggested a similar outlook for rate trajectory. While speaking at the National Association for Business Economics, he suggested that if the economy continues on its current trajectory, he expects two more smaller rate cuts this year, or cumulative rate cuts of 50 basis points at the next two meetings. FOMC projections also signalled a similar rate outlook for 2024 as signalled by the dot plot below.
YIELD CURVE RE-INVERTS
Bond yields have increased sharply to their highest level since August on tempered rate cut expectations.
Crucially, the increase has been much sharper for the 2-year yields indicating near-term expectations of elevated rates for longer.
The result has been a re-inversion in the yield spread with 2-year & 10-year treasury yields now on par. Notably, the yield futures spread has declined more sharply than the treasury yield spread.
HYPOTHETICAL TRADE SETUP
Recent economic data points to rising likelihood of a soft landing. Expectations of rapid rate cuts have tempered accordingly. While rates are expected to continue declining, the pace is expected to slow with a cumulative 50 basis points (“bps”) of further cuts in 2024 likely.
As rates remain elevated for an extended period, the yield curve has begun to invert again. With current inflation easing, the inflation premium on long-term treasuries has diminished.
FOMC projections suggest a gradual path toward rate normalization, suggesting a potential near-term yield curve inversion before it eventually normalizes. Investors can express views on this outlook through CME yield futures.
Further, the yield futures spread is trading at a (~5bps) premium to the treasury yield spread, as the futures contracts approaches expiry on October 31, the futures spread will converge towards the treasury yield spread which further benefits the short position.
CME Yield Futures are quoted directly in yield with a 1 basis point (“bp”) change representing USD 10 in one lot of Yield Future contract. This simplifies spread calculations with a 1 bp change in spread representing profit & loss 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 October 8, making this trade even more compelling.
A hypothetical trade setup comprising of long 2Y yield October futures and short 10Y yield October futures with reward to risk ratio of 1.5x is described below.
Entry: 13.5 bps
Target: -1.5 bps
Stop Loss: 23.5 bps
Profit at Target: USD 150 (15 bps x 10)
Loss at Stop: USD 100 (10 bps x 10)
Reward/Risk: 1.5x
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.
The September jobs report revealed 254,000 jobs added, significantly exceeding expectations of 147,000, with August figures also revised upward. This strong report, along with the JOLTS data from earlier in the week, indicates that the job market remains strong and not as weak as previously anticipated.
Despite the strong jobs data, the yield curve has inverted once again. While Mint Finance has previously highlighted that recession risks can lead to the yield curve inverting, that is not the only reason. This time around, the inversion is being driven by delay in rate cut expectations. CME’s Yield Futures enables investors to deftly express their views on the path of rates ahead.
JOB MARKET SHOWS MIXED SIGNS OF RECOVERY
The latest JOLTS figures showed U.S. job openings rising from 7.711 million to 8.090 million in August, with the previous month's numbers revised up by 38,000. Although job openings remain near a two-year low, the increase is a positive sign.
Rise in job openings was primarily due to increase in construction jobs (+138k), which are often seasonal, and government jobs (+103k). However, the overall report paints a mixed picture. Hiring fell by 99k from the previous month, and while total separations dropped by 317,000, the largest contributor was a 159,000 contraction in quits.
With fewer hires and a large drop in quits, the data suggests the job market is not particularly strong, as workers hesitate to leave their current positions with fewer being hired into new roles.
The Non-Farm Payrolls (NFP) showed 254,000 jobs added in September, with health care, social assistance, and leisure and hospitality sectors leading the gains. As a result of these additions, the unemployment rate eased to 4.1%. Hourly earnings grew by 4% YoY, with the previous month's figures revised upward to 3.9%.
RATE CUT EXPECTATIONS TEMPER
Further rate cuts are still expected, but the anticipated pace has slowed. Before the PCE inflation report on September 27, CME FedWatch indicated a cumulative 75 basis point reduction over the next two FOMC meetings in November and December.
Source: CME FedWatch
CME FedWatch tool also indicated a high probability of 100 basis-point cuts last month. However, after the encouraging PCE report, which showed inflation easing to 2.2%—its lowest level since 2021 and close to the Fed's target—the probability of a cumulative 50 basis-point cut has steadily risen.
Following the jobs report last week, the probability of cumulative 50 basis-points cuts surged to 80%.
The trend suggests that market participants are increasingly expecting a soft landing, with inflation easing and the job market remaining strong. A soft landing reduces the urgency for aggressive rate cuts, giving the Fed more flexibility to monitor the effects of previous rate hikes and lower rates more gradually.
Source: CME FedWatch
Crucially, Fed Chair Jerome Powell has suggested a similar outlook for rate trajectory. While speaking at the National Association for Business Economics, he suggested that if the economy continues on its current trajectory, he expects two more smaller rate cuts this year, or cumulative rate cuts of 50 basis points at the next two meetings. FOMC projections also signalled a similar rate outlook for 2024 as signalled by the dot plot below.
Source: FOMC
YIELD CURVE RE-INVERTS
Bond yields have increased sharply to their highest level since August on tempered rate cut expectations.
Crucially, the increase has been much sharper for the 2-year yields indicating near-term expectations of elevated rates for longer.
The result has been a re-inversion in the yield spread with 2-year & 10-year treasury yields now on par. Notably, the yield futures spread has declined more sharply than the treasury yield spread.
HYPOTHETICAL TRADE SETUP
Recent economic data points to rising likelihood of a soft landing. Expectations of rapid rate cuts have tempered accordingly. While rates are expected to continue declining, the pace is expected to slow with a cumulative 50 basis points (“bps”) of further cuts in 2024 likely.
As rates remain elevated for an extended period, the yield curve has begun to invert again. With current inflation easing, the inflation premium on long-term treasuries has diminished.
FOMC projections suggest a gradual path toward rate normalization, suggesting a potential near-term yield curve inversion before it eventually normalizes. Investors can express views on this outlook through CME yield futures.
Further, the yield futures spread is trading at a (~5bps) premium to the treasury yield spread, as the futures contracts approaches expiry on October 31, the futures spread will converge towards the treasury yield spread which further benefits the short position.
CME Yield Futures are quoted directly in yield with a 1 basis point (“bp”) change representing USD 10 in one lot of Yield Future contract. This simplifies spread calculations with a 1 bp change in spread representing profit & loss 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 October 8, making this trade even more compelling.
A hypothetical trade setup comprising of long 2Y yield October futures and short 10Y yield October futures with reward to risk ratio of 1.5x is described below.
Entry: 13.5 bps
Target: -1.5 bps
Stop Loss: 23.5 bps
Profit at Target: USD 150 (15 bps x 10)
Loss at Stop: USD 100 (10 bps x 10)
Reward/Risk: 1.5x
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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