It may seem like a bit of distraction in a market driven by news out of Ukraine, Gaza, Portuguese banks and Argentine default, but the long end of the Treasury yield curve deserves our full and complete attention.
The long end as measured by the forward rate ratio between 10- and 30-years (FRR10,30) has been flattening consistently since the end of November 2011, marked with a green vertical line below. This is the rate at which we can lock in borrowing for 20 years starting 10 years from now, divided by the 30-year rate itself The more this ratio exceeds 1.00, the flatter the yield curve is.
November 2011 was when central banks expanded their global currency swap lines, alleviated a dollar shortage for European banks and triggered a rally in global equities. The MSCI World index has returned 55.6% in U.S. dollar terms since then. The return on the duration-neutral bullish flattener, borrowing the 10-year and lending the 30-year, did not fare as well over this period. It returned only 5.75%. The current duration ratio would involve borrowing 2.2 10-year notes and lending one 30-year bond.
What are the current prospects for this trade? First, the net convexity gain on the trade is increasing once again. Convexity is the rate at which a bond's duration changes with respect to changes in interest rates. This is valuable to bond traders as a longer duration in a falling yield environment increases the rate of price appreciation. But higher convexity also increases a bond's interest rate risk, something we need to consider when real rates remain negative out to seven years. We saw last week just how twitchy the Treasury market could be when the GDP report came in stronger than expected.
If we sum this all up and map prospective returns on the duration-neutral bullish flattener as a function of net convexity gains and the FRR10,30, we find ourselves in terra incognita, wherever that is. Positive prospective returns on the flattener are marked with green bubbles, negative returns with red bubbles. The diameter of the bubbles corresponds to the absolute magnitude of the return. I marked the current environment with a bombsight. It has been drifting slowly to the northwest corner of the map and is out of range of more than 16 years of historical observation.
But the good news is there is nothing to suggest we are heading toward negative returns on the flattener. So long as the yield curve itself flattens and as net convexity gains are rising, we should remain in the flattening environment that has accompanied rising financial markets since November 2011.