Yield Curve Spread Provides Leader Indicator for Mortgage REITS

The yield curve spread provides a leading indicator for the stock price of $NLY, $AGNC, $MTGE and other mortgage REITs. The mortgage REIT sector has been pummeled this year, off as much as 30% while the DJIA and S&P 500 are up 18% and 23% respectively. 

Keeping a close eye on the yield curve can provide a leading indicator to the price action in mortgage REITs. As you can see in the charts below, the 2s10s yield curve spread flattened in March and April and then met significant resistance against its 200 day moving average in early May. The 2s10s yield curve moved sharply steeper in May moving above its 50 day moving average and to the upper Bollinger Band. The rout in mortgage REITs was officially underway.

2s10s Yield Curve Spread vs Mortgage REIT Equity Performance 

Source: CurveTrades and Google Finance

What does the yield curve tell us about what to expect next? October's rally in $NLY, $AGNC and $MTGE followed 2s10s moving below its 50 day moving average and to the lower Bollinger Band. Yesterday, 2s10s reversed and closed just above the lower Bollinger Band. If 2s10s steepens from the current 222 basis point level and heads toward 230 bps or higher, expect the mortgage REIT sector to trade off. 

An interesting long/short trade is long mortgage REITs and long the yield curve steepener. We will discuss alternative approaches to determine the hedge ratio in Friday's blog post.

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Crude Oil Prices and the Yield Curve Spread - Hoteling's Rule 2.0?

Hoteling’s Rule 2.0?

In 1931, Harold Hoteling published his article “The Economics of Exhaustible Resources” in the Journal of Political Economy.  In that article he argued that the net price of a natural resource (i.e. a non-renewable asset) must grow at the rate of interest. 

The principal concept behind that article is that the value of a unit of that resource must be equal to its market price at that time, p(t), less the cost of extracting it at that time, c(t).  That means that the marginal value, V(t), equals p(t) – c(t).  Hoteling argued that the asset’s marginal value elasticity must be equal to the rate of interest, r, so V’(t)/V(t)=r. 

We would like to understand the relationship of rates to price rather than to marginal value, if possible.  By making the reasonable assumptions that the marginal cost of extracting the resource is independent of the extraction rate and the cost does not meaningfully change through time, then c(t) becomes a constant c.  This simple assumption results in the resource’s price elasticity to be directly proportional to the level of rates.

The point we are trying to make is that the Hoteling’s Rule leads us to consider oil prices (NYMEX in particular) in relation to the general level of rates.  While a relationship may or may not be true in the long term, and there are many articles arguing for a far more complex relationship if there is a relationship at all, the change in spot oil prices do indeed seem to follow the change in rates.  However it is the 2yr/10yr UST futures spread (TUT) that, since the end of 2010, we argue appears to have a meaningful correlation. 

Both markets experienced rapid increases beginning in September – October 2010 which exhausted themselves in the April and May 2011 time frames respectively.  Both markets then declined into September 2011 after which the TUT traded sideways until March of 2012 while spot oil experienced a 30% rally.  However following March 2012 both markets declined into July 2012, largely traded sideways until May 2013, experienced rallies up to September 2013 then selloffs through today.

2s10s Futures Yield Curve Spread (TUT)

NYMEX Crude Oil Prices

At times we may observe that the correlation is low, consider the September 2011 – March 2012 period where TUT traded sideways but oil experienced a 30% rally.   That said there does seem to be a mean reverting aspect to the differential between to the two markets as is obvious in the relative moves from March 2012 and to July 2012. 

It is our view that an oil TUT spread position is worthy of closer examination and is an inherently lower risk proposition vis-à-vis an outright position in either market.  The key, as in all mean reverting strategies, is to optimize profit potential by initiating positions when the divergence reaches its exhaustion point.

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Yield Curve Spreads, QE3 and the U.S. Debt Crisis

Quick question, are U.S. Treasury yields higher or lower today that they were in early September? We are in the midst of a government shutdown (the sky has NOT fallen - that says a lot about federal government largesse) and we are staring down the possibility of a technical default by the United States. One would think yields would sky rocket while prices plummeted. Right?

Wrong.

Yields are significantly lower than the high prints of 5 September 2013.

	15-Oct-13	5-Sep-13	Difference
2 yr	0.35%	0.52%	-0.17%
5 yr	1.44%	1.85%	-0.41%
10 yr	2.72%	2.98%	-0.26%
30 yr	3.78%	3.88%	-0.10%

Source: U.S Treasury, Bloomberg

Higher yields equal higher risk premiums. But yields are lower now? The markets feared the end of QE3...a massive technical bid in the U.S. Treasury market. With the Fed's firm commitment to extend QE3 the market is not concerned with the bid going away, just slightly perturbed that the Washington politicians are acting like middle schoolers. 

The bottom line is that the market does not take the political brinksmanship seriously. The DJIA is off 0.30%, The S&P 500 is off 0.20%, the WSJ Dollar index is up slightly and U.S. Treasury yields are higher by 3 - 5 basis points.

Trade Weighted Dollar Index

So what does this mean for the bigger picture? The current media fueled political cat fight does not address the bleak underlying fundamentals of U.S. fiscal policy. These policies caused significant dollar depreciation. The front end of the yield curve is significantly steeper over the last 12 months. The U.S. Treasury futures 2s5s yield curve spread is 50 basis points steeper in the last 12 months. 

U.S. Treasury Futures 2s5s Yield Curve Spread

The 30 year secular bull market in bonds will end. With real rates of return on the 10 year treasury note at 0%, there is little room for income buyers or total return buyers to drive prices up and yields lower. The composition of the demand curve for U.S. Treasury securities has shifted dramatically in the last 20+ years. It is now dominated by central banks, which are not motivated by profit maximization. This topic will be covered in depth in a future blog post.

Yield curve spreads provide both a trading and diversification opportunity that is independent of outright interest rate levels. Keep yield curve spreads front of mind as you strategically position your portfolio across equites, credit, FOREX and commodities. CurveTrades makes it easy and provides valuable insight.

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The Yield Curve, The Dollar and the Government Shutdown

Renewed Focus and Trading Activity on the Yield Curve

There is renewed focus and trading activity on the yield curve and yield curve spreads given the U.S. government's shutdown and its impact on global financial markets. @AntoineGara reported on TheStreet.com Wednesday that the U.S. Treasury Bill curve inverted, with October 2013 maturities yielding more than November 2013 maturities.

This morning's news wires are cracking with reports that a 6 week deal of some sort is likely. Whammo!, a fresh look at the T-Bill curve shows December 2013 T-Bills now yielding more than January 2014 T-Bills. The yield curve inversion walked right out to the new point of uncertainty. If the rumored 6 week budget deal collapses, rest assured that the inversion will run back in to October.

This front end yield curve inversion impacts many markets - currency markets, eurodollars and the TED spread in particular. The Aussie dollar and the Euro are up again the U.S. dollar this morning. The TED Spread moves abnormally wider versus T-Bills over the inverted section of the yield curve.

U.S. Treasury Futures Yield Curve Spreads and cash U.S. Treasury Yield curve Spreads closed steeper across the curve yesterday reflecting the markets increased risk premium.

Futures and Cash Yield Curve Spread Market Overview

Trading Implications

Through the bulk of September, the 2s5s (TUF: 80 bps) futures yield curve spread and the 5s10s (FYT: 88 bps) futures yield curve spread flattened. The recent uncertainty reversed the flattening trend and TUF and FYT moved steeper. The TUF spread at 88 bps is 5 bps below its 50-day moving average. The FYT spread at 80 bps closed 3 bps north of its 50-day moving average.

2s5s (TUF) and 5s10s (FYT) Charts

The 10s-Bonds (NOB: 124 bps) futures yield curve spread steepened throughout September. NOB closed at 124 bps last night, 2 bps greater than its 50-day moving average and 1 bp above the intermediate term 62.8% Fibonacci level. Note that the NOB hedge ratio from the CME (currently 2:1) is off significantly. Don't let tail risk erode your performance.

10s-Bonds (NOB) Chart

Both cash and futures yield curve spreads are dynamic. Curve spreads react to economic data and monetary policy news while providing trading opportunities. CurveTrades tools and data allow you to recognize and develop your strategy as well as effectively manage risk.

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