Trading an inverted yield curve: why and how

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  Inflation, monetary policy, and a recession. Nobody is entirely sure of what's going to happen. Thus, it is critical to gain perspective and commit to a view. Here we discuss the inverted yield curve and how it can be traded depending on what you believe will happen in the foreseeable future.


After one year of maternity leave, I return to the office to hear the same thing from clients and colleagues: it’s a challenging market. Amid an ever-changing macroeconomic backdrop and monetary policies, putting money at work in a classic 60/40 style portfolio has become impossible. Nowadays, markets require investors to be tactical.

There is a problem, though: it's hard to be tactical when nobody knows what’s coming next.

The inflationary problem brought by the pandemic is unique in history. The world is shaping to be very different than pre-2020, and markets reposition frequently amid uncertainty. Some investors call for a soft landing, others for a recession. Some say rates will remain high, while others believe they’ll soon drop back close to zero. And the yield curve is a mess!

There is only one way to go: gaining perspective and positioning for the outcome that makes sense primarily to you.

In other words, I'm not here to tell you what will happen. I am here to display some market convictions and discuss how actionable they are in the bond market.

Why is the yield curve important?

Because it signals investors' feelings about risk and impacts investment returns.

Today’s inverted yield curve is a product of aggressive rate hikes, and it tells us that monetary policies today are more restrictive than they will be in the medium/long term. As the hiking cycle ends, it’s natural to expect it to steepen. Yet, it’s unlikely that the steepening process will be painless.

As many know, an inverted yield curve generally precedes a recession. In the past forty years, we saw an inverted yield curve only three times: before the Gulf War recession, before the dot-bomb recession, and before the great recession. If it's true that history repeats itself, we can rest assured the same thing is likely to happen also this time around.

What do you believe is going to happen?

  • You are in line with market expectations.

You believe that the Federal Reserve tightening cycle has come too far and that the economy will fall into a recession forcing the Fed to cut rates by 75bps by the end of the year despite firm inflation. This environment would give an edge to steepeners over outright longs. The most pronounced steepening will happen with short and middle-term Treasuries against the longer part of the yield curve, while the 10-year areas will serve as a safe haven. In this case, it's worth looking at 2s30s (ZT versus ZB) and 5s30s (ZF versus ZB) steepeners. Please refer to Redmond Wong’s article to learn how to trade steepeners with bond futures.

Because you’d expect a recession, buying the 10-year US note outright is also an option (US91282CHC82).

In the Saxo platform you can also find the Lyxor US Steepening 2-10 UCIT ETF (STPU:xmil), which rise as the yield curve steepens. 

  • You believe inflation will be sticky and that markets must push forward interest rate cuts.

Following the latest FOMC meeting, it’s clear that inflation remains the central bank's most significant focus. Thus, a tightening bias persists, and the Fed might not deliver interest rate cuts this year. In this case, it's too early to engage in curve steepeners. You might look to short the 3-month SOFR contract (SR3) or the 30-day Federal Funds future (ZQ) to express your view that the Fed won’t cut rates at the time the market expects.

In this scenario, it’ll be tempting to buy underpriced short-term TIPS. Yet, as the Federal Reserve holds rates, it might be time to turn to T-bills rather than floaters. For more information, please refer to this page.

  • In either case, the belly of the yield curve tends to outperform as hikes end.
A recent Bloomberg Intelligence report finds that the belly of the Treasury curve has outperformed before Fed easing cycles over the past five interest rate cycles. The report clarifies that the outperformance began about two months before the last fed move.

If rate cut expectations accelerate for 2024, the belly of the yield curve might outperform significantly.

In this scenario, one should look for outright US Treasuries with a maturity that ranges from 3 to 6 years. It's possible to use the Saxo screener to find a list of bonds that matches these criteria (please refer to the below).
Source: Saxo Platform.

It's also possible to use bond futures to gain exposure to the belly of the yield curve. One of the most used strategies for this purpose is the butterfly strategy, which consists of buying two times the belly and selling the wings.

Let’s assume the 5-year (ZF) bond futures contract is going to surge faster than the 2-year (ZT) and the 10-year (ZN) contracts. Therefore, our butterfly would look like following:

B = 2*ZF – ZT - ZN

However, to ensure that the butterfly moves only as the yield curve changes, it’s key to neutralize duration through a hedge ratio as described in Redmond’s article.

Once the weighting is correct, we’d insert two trades:

1. 
Sell ZT and Buy ZF
2. 
Sell ZN and Buy ZF

Quarterly Outlook

01 /

  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.