Bond market's great reflation trade upended by Fed intervention

The mere hint that the Fed may take additional steps to hold down long-term rates is causing Treasury traders to scale back so-called steepener bets -- a tried-and-true strategy that has generated big profits over the years as economic rebounds pushed yields higher. Barclays is keeping a lid on the size of its positions. Incapital is using options, rather than actual bonds, for a hedged -- and more cautious -- riff on the trade. And Nick Maroutsos of Janus Henderson Investors says some "could get flattened" by the wager.

It's the latest example of how the Fed's outsized presence in markets, which began with the 2008 financial crisis and shows no signs of ending, is distorting traditional trading strategies: It's squelching volatility, adding fuel to a record-setting advance in stocks, leaving credit markets priced to perfection, and curbing Treasury yields at levels that no longer fully reflect market sentiment or investors' belief in the economy.

Were it not for Fed policymakers frequently affirming that they'll do whatever it takes to bolster the economy -- comments that accentuate the commitment they made this summer to keep rates low for as long as they can -- the 10-year yield would likely already have bounced back above 1%. Perhaps, well above it, some say. Instead, it's edged lower every time it's come close to that level since March, dragged down by traders worried the Fed could adjust its bond purchases as soon as next week's meeting. Policymakers have said a hard cap on yields remains in their toolbox.

"It's hard for a trader to have any conviction, when you are just one announcement away from the Fed crushing your trade," said Patrick Leary, senior trader and chief market strategist for Incapital, a Chicago-based underwriter and distributor of corporate bonds. "You don't want to put it all out there or ride a trade for too long."

For months, investors have been trained to buy bonds on price dips, given the perceived readiness of the Fed to prevent an alarming increase in rates. Even when last week delivered one of the biggest daily spikes of 2020, 10-year Treasury yields failed to breach 1%. They're now at about 0.9% -- despite similar-maturity breakeven rates continuing to rise as stock and metals markets price in reflation. The yield curve from 2 to 10 years, after touching a three-year high above 80 basis points on Dec. 4, has also retreated.

Higher yields are a double-edged sword for the Fed. On the one hand, they can signal greater confidence in the recovery and, indeed, officials might even welcome them if they're accompanied by rising inflation expectations. But the flip side is that rates that climb too much also raise long-term borrowing costs, which is one of the last things the economy needs with the pandemic raging and millions still out of work.

With market expectations for Fed action tamping down yields, traditional signals sent by those rates have become less reliable for interpreting investor sentiment. What's more, low rates have diminished the returns from bonds that many investors count on to offset any equities losses, forcing them to seek new hedges.

"The Fed's manipulation of the bond market is good in theory, but producing multiple reactions with unintended consequences," said Larry Milstein, senior managing director and head of government debt trading at R.W. Pressprich & Co. in New York. "The Fed is the 800-pound gorilla in the room, and there's a risk that it could step in at any time and flatten the curve."

Speculation is rife that the central bank will either offer guidance on or adjust its bond-buying program as soon as its meeting on Dec. 15-16. The majority view is that it will ultimately shift its purchases -- now totaling about $80 billion a month in Treasuries -- more to longer maturities, if needed, to support economic bright spots such as housing as the pandemic rages on.

It's certainly been a year in which the Fed has dug deep. From the initial rate cuts and emergency aid programs of March to its decision to place inflation at the heart of its monetary policy, the central bank has taken a proactive approach, with officials reiterating their sensitivity to markets. Fed Chair Jerome Powell has repeated that he's "not even thinking about thinking about raising rates," Richard Clarida -- his deputy -- has said yield-curve control is still part of the Fed's tool kit, and Randal Quarles, vice chair for supervision, opened the door to unending quantitative-easing to support Treasury trading.

Still, that's not stopped the likes of Bank of America Corp. and Societe Generale SA from recommending steepeners this year on expectations that stimulus by both the government and central bank will bolster the economy and boost yields. But Goldman Sachs Group Inc. has shifted to a more nuanced view, targeting a steeper curve via forward contracts instead of spot positions.

At Barclays, Kevin Walter -- co-head of global Treasuries trading -- says he's holding a small position in bear steepeners when he would ordinarily have a bigger one to reflect his view that the economy is on the right track, given prospects for a vaccine and fiscal stimulus.

"One thing holding me back is the possibility that, as soon as this next FOMC meeting, the Fed could be extending WAM," or the weighted average maturity, of its purchases.

If that happens, it would cause longer maturities to outperform, creating an opportunity to put on more bear-steepener trades from a better level, he says. Even so, he sees a policy shift by the Fed as more likely next quarter.

Maroutsos at Janus, which managed about $350 billion as of September, says he "tip-toed" into a mild steepener earlier this year, and refrained from adding more in the Absolute Return strategies he helps oversee, partly because he viewed it as a crowded trade that could unwind "fast and violently."

"We weren't firm believers the curve would steepen anyway, and it's been hard for us to get on board," he said. "There are too many extenuating circumstances that could result in that trade being hurt," such as renewed lockdowns and the prospect that a fiscal package doesn't get passed.

Many traders began paring steepener bets last month as they reassessed the potential for more support from the Fed.

Leary of Incapital says he pulled back on the popular trade to take profits in early November, when the 10-year Treasury yield approached 1%, and positioned instead for more flattening. He's now expressing his optimistic views on the economy via a synthetic trade that mimics the steepener -- buying puts on 10-year options and calls on 2-year options, which have built-in stop outs "if I get it wrong." He sees the 10-year yield falling to as low as 0.65% to 0.75% if the Fed tweaks its bond buying this month.

The Treasury's decision not to extend some emergency Fed lending programs past year-end increased expectations that policy makers will act soon. Yet recently, somewhat more optimistic comments about the economy from Powell seem to have removed some of that urgency.

Even if the central bank doesn't act next week, the U.S. faces a tough stretch ahead with the pandemic. All else equal, that should bolster demand for Treasuries, lowering yields -- and make steepeners a riskier place to be through at least the year-end.

Caution toward steepeners has "definitely been a topic of conversation" among portfolio managers at Insight Investment, which oversees about $945 billion, says Jamie Anderson, head of U.S. trading, adding that the Fed can't be blamed for putting the economy above traders.

The steepener is "definitely a position that everyone loves," Anderson says, but there's a lot at stake over the next few weeks. "You could ultimately be right, but the events before you get there could be extreme and everyone has a limit somewhere."