Trading Inflation & Deflation

“Many people fear nothing more terribly than to take a position which stands out sharply and clearly from the prevailing opinion. The tendency of most is to adopt a view that is so ambiguous that it will include everything and so popular that it will include everybody. Not a few men who cherish lofty and noble ideas hide them under a bushel for fear of being called different.” — Dr. Martin Luther King, Jr.

Chart of U.S. 2yr Treasury Rate (area graph) vs. U.S. 30yr Treasury Rate (purple line)

The global reflationary theme, looming U.S. debt ceiling (29th Sept 2017) and weak Dollar (against G10 currencies) is a peculiar situation that presents interesting opportunities in the U.S. debt market.

Divided on the reflationary narrative. The treasury curve has been flattening in the wake of a reflationary narrative, long dated bonds are clearly calling the Fed bluff, shorting any hawkish interest — 30yr rates are falling (purple line) vs. 2yr rates (area graph).

Weak Dollar. Dollar looks to be finding a bottom across the board, but macro backdrop appears murky and unpredictable. September will be a trying time for the greenback as talks about the debt ceiling should bring about unprecedented volatility.

In the chart above, the common thread across volatile regimes is the fact that long dated bonds are robust to debt issues and antifragile when it concerns a market correction. The dominant trade in Q3 leading up to the U.S. debt ceiling will be Long 2yr Treasury rate and Short 30yr Treasury rate simultaneously. Trading the flattening of the 2–30s yield curve.

Here are some charts to help with the thought process:

Short dated bonds are more sensitive to issues pertaining a potential default. In the event of a credit crisis, money will be unwound from the short end of the curve (short dated rates will be sent higher) to be parked at the long end. The period of government shutdown during the Obama administration in 2013 is a good example (Red Circle). The event flattened the 2–30s spread as 2yr U.S. yields soared while 30yr remained steadfast.

Same thing happened in the 2015 debt debacle.

Given the current reflation theme and debt ceiling, the dominant way to trade the

Short term inflation narrative + Long term deflationary belief + potential credit event will be to long the 2–30s treasury spread. The 2yr rates will be swept up and away by short term speculators and Fed tinkering while 30yr rates continue to call bullshit*. As we approach peak euphoria in tech and financials, 2–30s will get a boost from a market correction.

As a benchmark, I believe the 30–10 (NoB Spread) will trade back down to 0.25%.

Tread Lightly,

Nicholas Koh