Will Interest Rate Spreads Peak? Our Interest Is Piqued!

Interest Rate Spreads

The interest rate markets have historically provided many good spread trading candidates. Potential trading opportunities could be shaping up in a few of them right now.  

Some interest rate spreads are based on the relationship between debts of different durations for the same country. (For instance, the long-term US 30-year bond against a medium-term US ten-year note). This is a traditional yield curve trade. 

T-bonds T-notes overlay monthly

T-bonds T-notes overlay monthly

The spread between 30-year bonds and 10-year notes are extremely correlated as they almost always move together in the same direction.  As a crude rule of thumb, one could state that the only difference between these two markets is that the 30-year bond moves about 40% faster than the 10-year note.

Other interest rate spreads are based on the relationship between the debts of different countries with the same duration. (For instance, the US ten-year note against the Canadian ten-year bond). This is an inter-market Treasury trade.

Let’s take a quick look at the first kind of spread.  

The T-bond/T-note Spread

The Fed’s QE program has kept a bid in the US bond market for the last few years. This has pushed the US Treasury market to historic highs and rates to rock-bottom lows. The Treasury spread has also been affected.

T-bonds T-notes spread monthly

T-bonds T-notes spread monthly

Historically, the T-bond/T-note spread has usually been a good candidate for a short sale whenever the T-bonds reached a premium of five points or more over the T-notes. No matter how high it went, the spread would ultimately reverse and erase the entire premium. Even in the depth of the financial crisis when the T-bond/T-note spread reached an all-time high of nearly fourteen points (premium T-bonds) at the end of 2008, it ultimately collapsed. The spread made it back to ‘even money’ (meaning that the prices of bonds and notes were the same) a little more than four months after the peak.

For the last three years, however, the T-bond/T-note spread has stayed far north of the ‘even money’ mark. After posting a new all-time high of just over eighteen points (premium T-bonds) in November of 2012, the one-year decline ended just below five points with the T-bonds still trading at a premium to T-notes.

On Thursday, August 28th the T-bond/T-note spread traded one-quarter of a point shy of last year’s peak, basis the nearest-futures. It has recovered about two-thirds of the entire drop from the November 2012 all-time high. Here’s the $64,000 question: Is this a manifestation of the ‘new normal’ that Bill Gross talked about or is this just a prolonged deviation from the mean that will eventually experience capitulation?

Regardless of the longer-term answer, it would seem that the T-bond/T-note spread is vulnerable to some sort of a reversal in the medium-term. There are two fundamental reasons for this. First, the Fed continues to unwind their QE bond buying program and the consensus is that a rate hike will come in 2015. Second, the government is projected to auction off $238 billion in Treasury supply in the second half of the year vs. the $133 billion that was auctioned off in the first half of the year. That’s a noticeable increase in supply.

Timing the reversal is the real issue, of course. We are not economists; we are traders. Therefore, we must be right and at the right time. In this business, being right early is still being wrong.

Looking at the daily and weekly time frames, there are three possible signals that one can use to identify a bearish trend change signal in the T-bond/T-note spread:

T-bonds T-notes spread daily

T-bonds T-notes spread daily

On the daily time frame, the dip in early July is the only time since the mid-November low was made that the most-active T-bond/T-note spread traded below a prior month’s low. It was a mere two and a half tick infraction, at that! Therefore, a close below a prior month’s low would alter this bullish price structure.

Also on the daily time frame, the pullbacks have been pretty uniform. Since the mid-November low was made the T-bond/T-note spread made several pullbacks of one to one and a half points from the peaks before it reverses and races to new highs. Therefore, any decline of two points or more from the high would signal an overbalancing of price and alert us to a trend change.

T-bonds T-notes spread weekly

T-bonds T-notes spread weekly

On the weekly time frame, a bullish trend change was signaled at the start of the year when the nearest-futures T-bond/T-note spread closed above the declining 20-bar Moving Average (by at least one-quarter of a point) for the first time since May 2013. The spread has continued to close above the weekly 20-bar MA every week since. Therefore, an end-of-week close below the weekly 20-bar MA (by at least one-quarter of a point) could signal a bearish trend change.

Trade Strategy:

The blog will make a hypothetical trade by shorting one December T-bond contract and simultaneously buying one December T-note contract if the nearest-futures spread makes an end-of-week close below the weekly 20-bar MA (by at least one-quarter of a point). Initially, the spread will be liquidated on a two-consecutive day close 8/32nds (one-quarter of a point) above the contract high that precedes the trend change signal.

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