Trading an inverted yield curve: why and how

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.