The curve is too steep, not too flat

US YIELD CURVE UPDATE
THE CURVE IS TOO STEEP, NOT TOO FLAT
TIMOTHY HIGH
US INTEREST RATE STRATEGY
NEW YORK, 6/14/2016
The yield curve is too steep, not too flat
There has already been much more Fed tightening this cycle than is shown by nominal Fed funds.
 Nominal Fed funds fails to express the true extent of monetary easing during quantitative easing (QE). Just as implementing QE was an
easing of policy, removing QE was a tightening: the Atlanta Fed’s Shadow Fed funds rate expresses this effect. This makes the Shadow
Fed funds a better metric of monetary policy than nominal Fed funds.

Shadow Fed funds shows that monetary policy has tightened by an effective 350bp since Q2 2014.
 The economy is now weakening, which suggests that policy is already tight enough: the policy cycle should be ending, not beginning.
Given the true extent of Fed tightening to date, and the growing risk of recession, the yield curve is too steep, not too flat.
 Using Shadow Fed funds to express the extent of the hiking cycle to date, and comparing this cycle to previous hiking cycles, we find that
the yield curve is too steep given the extent of tightening that has already taken place.
 Those saying that the current flatness of the yield curve signals the possibility of recession are correct, but it should be flatter. Our
economists put the odds of recession at 40-50% (Macro Matters, 9 June, page 2).
 If the nominal curve flattens, the Adrian, Crump, Moench (ACM) term premium may fall further.
Trade recommendations:
 2s10s Treasury curve flattener: Entry: 90bp. Current: 88.5bp. Target: 60bp. Stop: 103bp. 3m carry + roll down: -5bp.
 2s10s swap curve flattener: Entry: 63bp. Current: 60.5bp. Target: 33bp. Stop: 75bp. 3m carry + roll down: -1bp.
 Buy 10y Treasury: Entry: 1.75%. Current: 1.60%. Target: 1.40-1.50%. Stop: 1.90%. 3m carry + roll down: 4.25bp.
 Conditional bull steepener. Buy 1x 12/16/16-10y atmf vs atmf -25bp receiver spread vs selling 38x 2EZ8 99.25 midcurve call*
(atmf – 41bp): Entry: 6c. Current: 6c. Target: 188c (20bp). Stop: -50bp (-5.25bp). 3m carry + roll down: 43c (4.5bp).
*Call on EDZ8 expiring at EDZ6
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Shadow Fed funds implies the tightening cycle began in October
2014
The Atlanta Fed developed the Shadow Fed funds rate
(working paper) which calculates an effective Fed funds rate
which considers the easing from QE:
Shadow Fed funds fell to -2.75% in mid-2014
 QE caused the Shadow Fed funds rate to fall to -2.75%
in mid-2014.
 Shadow Fed funds began to rise considerably precisely
at the end of QE tapering (October 2014 FOMC
meeting).
 The Fed has thus been tightening since October 2014,
not December 2015.
Source: BNP Paribas, Bloomberg, Macrobond
3
Put simply, what is the Shadow Fed funds rate?
The Atlanta Fed introduced the concept that the Shadow Fed
funds rate better expresses the impact of monetary policy at
the zero lower bound (ZLB) than conventional expressions.
Further, the shadow Fed funds better kept the link between
monetary policy and macroeconomic data.
The explanatory power of SRTSM
Historically, the term structure of the yield curve has been
explained by its level, curve, and convexity. Typically, the
Gaussian affine term structure model (GATSM) has been
employed but ran into limitations at the onset of QE:
 GATSM ran into trouble explaining short rates with
such a long period at the ZLB.
 The shadow rate term structure model (SRTSM) has
proven useful in measuring the stance of
unconventional monetary policy.
 SRTSM effectively allows 0% calls to have value.
STRSM has historically correlated to macroeconomic
variables. Therefore, it correlates to the behavior, but not
necessarily the level of the short rate implied by the Taylor Rule.
Source: “Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound” by Jing Cynthia Wu and Fan Dora Xia
The Taylor Rule
 Taylor Rule assumptions: neutral real Fed funds rate =
0%, PCE = 2.0%, NAIRU = 4.80%
During the QE period (which ended with tapering in October
2014), the shadow rate vs nominal Fed funds upper bound fell
to as much as -3.25%. This implies that QE continued the easing
cycle from 2009 to 2014 and a steeper curve (2y – shadow Fed
funds).
Source: BNP Paribas, Bloomberg
4
Evidence that the Shadow Fed funds is a better index of monetary conditions
The behavior of crude oil and risk assets was easing and tapering
began the tightening cycle:
A powerful link to QE
 Crude oil and high yield credit fell quickly at the end of QE
tapering (end of the easing cycle) and the dollar rose.
 The fall in crude oil was certainly caused in part by OPEC’s
refusal to cut supply. However, upon further review, there
was a demand shock as well.
 End of easy money puts risky assets in the crosshairs; and
The economy is now showing signs of weakening:
 Recent weakness in the labor market is not just “one data
point” and should not be ignored.
 The fall in the Fed’s Labor Market Conditions Index (LMCI) is
picking up steam.
 We expect wage pressures to reduce corporate profit
margins. This may be slowing hiring and ultimately lead to job
losses.
Source: BNP Paribas, Bloomberg, Macrobond
LMCI has been sending warning signs all year
 Our economists put the odds of recession at 40-50% (Macro
Matters, 9 June, page 2).
 This is not an environment to continue tightening.
Source: BNP Paribas, Bloomberg, Macrobond
5
US economy is weakening so this should be the end of the tightening cycle
We feel that the recent fall in the 3m moving average on nonfarm
payrolls is one (important) indicator of a slowing economy:
2s10s can invert at the end of tightening cycles
 Our economists believe that the tightening cycle is over. We
expect no rate hikes in 2016 or 2017.
 At the end of prior tightening cycles, the 2s10s Treasury
curve reached zero or inverted.
 At 88.5bp, the implication is the curve is too steep, not too
flat.
Source: BNP Paribas, Bloomberg, Macrobond
6
Contrasting messages for the curve from nominal and Shadow Fed funds
Using nominal Fed funds and the assumption that the tightening cycle
began in December 2015, the curve appears too flat:
Nominal Fed funds implies that the curve is too flat
 This completely ignores the concept of Shadow Fed funds and
QE being a form of easing.
 The Fed has said QE is easing.
 Why create Shadow Fed funds and ignore it?
 Financial markets provide clear evidence that Shadow Fed funds
should not be ignored.
We compare prior tightening cycles to the current one assuming
Shadow Fed funds is the correct base rate:
 The 2s10s Treasury curve began the current cycle in line with
prior tightening cycles.
Source: BNP Paribas, Bloomberg, Macrobond
2s10s is far steeper at this point than in prior cycles
 The amount of tightening so far is in line with the full cycle
tightening in the past.
 At this point in the 1994 and 2004 cycles, 2s10s was flatter by
50bp and 100bp, respectively
Source: BNP Paribas, Bloomberg, Macrobond
7
Will the ACM term premium make new (negative) lows?
Shadow Fed funds was -2.75% at the beginning of the current
tightening cycle, therefore the ACM risk neutral 10y – Shadow Fed
funds was nearly 500bp:
Will curve flattening push ACM term premium to new lows?
 At this point in the 1994 and 2004 cycles, ACM 10y – Shadow
Fed funds was flatter by 255bp and 172bp, respectively
 This implies that the ACM risk neutral 10y yield could have
been much lower, perhaps raising the term premium much
higher.
When Japan accelerated buying US Treasuries in mid-2015, the
term began falling and is currently -50bp.
 Therefore, the impact of BOJ QQE and ECB PSPP is a key
driver of the level of 10y yields and the term premium.
 If 2s10s bull flattens as we expect, either the ACM risk neutral
10y yield falls in line with the nominal 10y yield or the ACM
term premium will make new (negative) lows
Source: BNP Paribas, The Federal Reserve, Bloomberg, Macrobond
QE abroad is a key driver of US term premium
Source: BNP Paribas, Japan Ministry of Finance
8
Trade recommendations
2s10s Treasury curve flattener: Entry: 90bp. Current 88.5bp. Target: 60bp.
Stop: 103bp. 3m carry + roll down: -5bp.

Does not rely on a directional move from the broader level of rates.

Negative carry is not optimal.
Swap and Treasury curves act similarly in tightening cycles
2s10s swap curve flattener: Entry: 63bp. Current: 60.5bp. Target: 33bp. Stop:
75bp. 3m carry + roll down: -1bp.

Does not rely on a directional move for the broader level of rates
and is subject to minimal negative carry.

Exposed to volatility in swap spreads.
Buy 10y Treasury: Entry: 1.75%. Current: 1.60%. Target: 1.40-1.50%. Stop:
1.90%. 3m carry + roll down: 4.25bp.

We recommend waiting for a pullback if entering a new trade. The
market may be locally overbought. Our Q3 target is 1.55%, but an
overshoot in the interim is very possible.

Positive carry cushions against a potential selloff.

Completely exposed to a rise in yields.
Source: BNP Paribas, Bloomberg, Macrobond
6m10y receiver spread vs midcurve call
Conditional bull steepener. Buy 1x 12/16/16-10y atmf vs atmf -25bp receiver
spread vs selling 38x 2EZ8 99.25 midcurve call* (atmf – 41bp): Entry: 6c.
Current: 6c. Target: 188c (20bp). Stop: -50c (-5.25bp). 3m carry + roll down: 43c
(4.5bp).

Conditional on lower rates. Rising rates decays the delta and
ultimately the terminal value would be zero.

Slow burning trade, aided by positive carry.

Entry point in terms of carry supported by attractive 6m roll down.

Terminal 10y – ED11 (generic for current EDZ8) curve breakeven ,
currently 80bp, is 10bp above post-taper highs.

The trade is exposed to fear of negative nominal short rates.
Source: BNP Paribas, Bloomberg, Macrobond
*Call on EDZ8 expiring at EDZ6
9
G10 IR Strategy contacts
Laurence Mutkin
Global Head of G10 Rates Strategy
+44 20 7595 1307
laurence.mutkin@uk.bnpparibas.com
Patrick Jacq
Europe Strategist
+33 1 4316 9718
patrick.jacq@bnpparibas.com
Eric Oynoyan
Europe Strategist
+44 20 7595 8613
eric.oynoyan@uk.bnpparibas.com
Ioannis Sokos
Europe Strategist
+44 20 7595 8671
ioannis.sokos@uk.bnpparibas.com
Camille de Courcel
Europe Strategist
+44 20 7595 8295
camille.decourcel@uk.bnpparibas.com
Parisha Saimbi
Inflation Graduate Strategist
+44 20 7595 8351
parisha.saimbi@uk.bnpparibas.com
Agne Stengeryte
Graduate Strategist
+44 20 7595 8958
agne.stengeryte@uk.bnpparibas.com
Timothy High
US Strategist
+ 1 212 841 2842
timothy.high@us.bnpparibas.com
Daniel Totouom-Tangho
US Strategist
+ 1 212 841 2437
daniel.totouom-tangho@bnpparibas.com
Sarah Hu
MBS Strategist
+ 1 212 841 3713
sarah.hu@us.bnpparibas.com
Philip Patterson
MBS Strategist
+ 1 212 841 2977
philip.patterson@us.bnpparibas.com
Tomohisa Fujiki
Head of Interest Rate Strategy Japan
+81 3 6377 1702
tomohisa.fujiki@japan.bnpparibas.com
Reiko Tokukatsu
Relative Value Strategist
+81 3 6377 1704
reiko.tokukatsu@japan.bnpparibas.com
Altaz Dagha
AU & NZ Strategist
+ 65 6210 4994
altaz.dagha@asia.bnpparibas.com
10
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