The Fed is expected to begin its process of normalizing rates this December. Recent commentary from Fed’s Bullard (hawk), who is a non-voting member until he joins the member rotation in 2016, alludes to a greater than 50% chance of a hike as early as Sep. Getting short the TUT (A yield spread constructed by selling the 2 year US Treasury Note simultaneously buying the 10 year UST) has been a popular strategy for some longer-term players, in the midst of past Fed hike cycles. The generally accepted theory is that the TUT is an appropriate proxy of the yield curve itself, and that the yields on the short end will rise much more rapidly than on the long end. Longer term traders, the rare investors with investment time horizons longer than picoseconds, will be carefully eyeing the TUT over the next several months. The question is, will it be the same this time and how will the front-end-lead-bear-flattener trade be timed?

Taking a closer look at the historical TUT spread chart, it is clear that unemployment, one half of the dual Fed’s dual mandate, has had a lead-lag-love affair with the FFR directly and correlates well with the TUT yield spread. This is no coincidence. Unemployment may prompt Fed policy; however, policy action has to be sustained in order to pare back adverse movements in employment. Historically, the TUT is no different. Overall, the impact of inflation on the TUT and FFR are clear, especially through the 2001 “shock and awe” policy era and the aggressive 2004 hike campaign.

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*Please note that the TUT is traded and price charted as 2yr – 10yr, however the yield spread is charted the opposite way (10 yld – 2 yld) such that the increase in the TUT yield corresponds to steepening and a decrease in the TUT yield corresponds to tightening.

The current pecking order for Fed policy normalization seems to be to lift rates gradually, in the not so distant future, and to later begin an exit from their 5+ trillion dollar MBS and long term treasury holdings. This can create a situation that tempts TUT traders to hang short. However, the pecking order is not carved in stone which can create a slightly different situation this time around, as when the Fed begins their exit and sells off long term treasury holdings, the yields on those securities may increase at a faster pace than on the short end of the curve, especially if the pace of that exit takes place more rapidly than expected. In essence, a reversal of the pecking order or even a simultaneous policy path may put pressure on TUT shorts who are expecting it to play out like it did in “the old days”. Mind the squeeze, players, mind the squeeze.

Early birds and short term punters have been squeezed out of this play a couple of times already, as the Fed teeters and it may be some time before the Fed commits to its policy path. The TUT bounced from the Feb low yield of 1.27 to 1.58 (last). Looking to the historical chart, it appears that there is a short lag, in that the TUT begins to move more rapidly once the policy path becomes clearer and underway. It can be some time before this takes place in the current market. The Sep meeting seems an unlikely candidate for the first hike. Despite the recent commentary from Fed’s Bullard, the Sep meeting is currently pricing in just under a 30% likeness for a 25bps hike. December is a much more likely case, however there remains 6 more CPIs, NFPs, two Fed meetings, and a bevy of other data that could ultimately swing the decision either way before the Dec meeting. Even if the market is taken by surprise with an earlier than anticipated hike, it is quite likely that the Fed will take on a gentler path forward than what was exhibited during the tail-end of the Greenspan era, wherein the rates were hiked 17 times consecutively, unless there is a significant acceleration in core inflation or some other extreme adverse economic event.

At present the TUT is being traded at 2:1 (2yr – 10yr) for the current roll, DV01 ratios have been volatile as of late, last roll was trading at 7:4. In today’s marketplace, those without access to trade overnight futures or cash Treasuries, can look to the likes of TLT, TBT, SHY, IEF and several other UST ETFs to construct a curve play and follow the action.

-David Felkai

Uptick GMA.

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