First off, my apologies for the delay. Second, I have no idea how to use this site so I'll just link this whole chain at once instead of responding to people separately. Lastly, to be clear, I'm talking about going long the short duration and short the long duration particularly when the yield curve is negative.A position that exploits the 10y-2y spread is a steepener, is it not? I assumed that was what user SongOfTheFates meant. To make money from the widening spread of the 10 year and 2 year, which is what generally happens around recessions, you would need to go long the 2 year note while shorting the 10 year note.I don't think it makes sense, because if you read the papers posted earlier in this thread, the Sharpe ratio is higher the lower the maturity of the treasuries down to about 12 months. So you would be short the most profitable part of the yield curve, and also the part that is the most un-correlated or anti-correlated to equities during equity market crashes.I would be interested to hear more details about your yield spread (overlay?) and how you plan to systematically apply your exposure to this spread in the context of a mHFEA portfolio.Hey folks! Thanks for all the research and discussion you've all documented here.
I've been making my way through the thread, but has there been much discussion about using treasury spreads to hedge instead of going long treasuries? I've been eyeing using the 10y-2y and 10y-3mo SOFR futures and on a surface level it seems to be pretty cohesive as long as you're treating it as a tool you apply sparingly instead of a comprehensive 'portfolio' you can hold and backtest for 30+ years.
I'll elaborate more when it's not 3am where I'm at
As I recall, the 10y-2y spread has about a 0.5 Pearson correlation coefficient to the unemployment rate from about 1953. So it is a proxy for the business cycle. However, going long this spread would not have helped in the most recent, 2022-2023 drawdown in equities and bonds, for example. In fact it would have been an additional drag on the portfolio. So I am curious how this additional tool could be used to improve mHFEA.
Earlier in this thread I instead proposed a curve steepener as a perpetual or strategic position, i.e. an exaggerated version of mHFEA that is not constrained by >0% allocations on the yield curve. The 0% constraint as you move from HFEA to mHFEA seems arbitrary.
For example, +200% ITT and -50% ITT-equivalent LTT as a partial hedge of the ITT for a 150% ITT-equivalent total target duration exposure, but with better risk-adjusted performance as LTT has lousy risk-adjusted performance. LTT, for example the UB future or perhaps even better the 30-year swap futures contract, is the black sheep, if the premise of mHFEA is right.
The slope between 20y and 30y has historically been rather negative - almost the entire history, except ca. 5 years during ZIRP: viewtopic.php?p=7470297#p7470297
A steepener did not help during the 2022-2023 drawdown in stocks and bonds. I made this comment just in case this overlay to mHFEA had been suggested as a way to help in a bonds falling/stocks falling scenario. I could imagine that overlaying a steepener onto mHFEA should enhance returns around recessions, and perhaps diminish returns around the peak of the business cycle. But I am curious what is meant by:To me, this implies some kind of systematic approach.as long as you're treating it as a tool you apply sparingly instead of a comprehensive 'portfolio' you can hold and backtest for 30+ years.
Thinking out loud, I wonder if there is a more reliable negative correlation between equity returns and the 10s 2s (duration neutral) steepener than there is between short term treasury returns and equity returns. Maybe worth having a look.
I don't think it not helping during 2022-2023 is looking at it the right way. It doesn't really make sense to go long the 2 year and short the 10 year when the spread is significantly positive, especially looking at the economic conditions around 2021 going into 2022. If anything you should bet on the exact opposite position just going by historical precedence and thinking about the practical concerns with lending money in an inflationary environment.
But let's look at what a steepener can do, objectively speaking. Going long the 2y and short the 10y in whatever ratio cancels out your interest rate risk has three very desirable properties;
(1) Extremely significant correlation with market crashes.
(2) Better interest returns in the current market environment of an inverted curve.
(3) Extremely limited exposure to straight interest rate movements.
I think that on a surface level, these makes it worth inspecting more deeply when the yield curve is negative. I don't have any statistical analysis to prove (1) or the 'strength' of it since I just did some back of the napkin math during my initial analysis and that was enough for me, but I think it's fair to say that a quick look at the FRED data on it would show that a sharp steepening in the yield curve is highly correlated with significant recessions. (3) is however the most interesting in my opinion, since it lets you carefully pick and choose when you want to swap to long bonds.
This current situation is a perfect example of this; The next two days have some major economic data being released. I think that the last few years have demonstrated that interest rate risk is a very real risk of investing in bonds, so I'll ask: why take the risk of holding longs bonds when this alternative exists? I just don't really see the point of going hard into the STT/ITT's or whatever the canonically prescribed durations are. They've got negative absolute returns just accounting for the cost of financing through futures from June 2022, not even mentioning what happened to the actual value of bonds with rising rates. Since July 2022 (the first time the 10y-2y went negative) the steepener has outperformed just straight ITT's. If you take an actually sensible entry point of the first reversal of the trend once it goes negative (Dec 2022), you get a much nicer entry that's already at break-even despite taking a loss in the months after. I'm using the FRED data for this by the way, I'm not sure new users are allowed to post links so I'll refrain from doing so.
What kind of economic situation leads to a continued or worsening inversion? I can think of a few extremely short-duration ones, sure, but logically more dramatic inversions lead to more exceptional reversals when the market corrects. Fundamentally speaking, it doesn't make sense to lend out for less money for 10y than 2y or 3m. My bet is that, essentially, either there'll be a recession and the STT rate absolutely tanks beyond the LTT and ITT's, or that ITT and LTT's get absolutely crushed as the market adjusts to the long-run natural interest rate being higher than currently priced in. Or a slow drop of STT's while ITT's and LTT's stay where they're at. I have a significantly easier time imagining a world where those outcomes happen over a world where the yield curve perpetually grows more inverted.
Finally, I've got nothing against long bonds. I think the STT's in particular are a really good hold once the cuts start rolling in, I just think they'll be a bit later than the market's currently pricing it in. My investment objectives are also very different from most people: I'm not saving for retirement because I'll very likely die before then, so my goal is strictly to make as much money as possible as quickly as possible, taking on significantly more risk of ruin than most should be willing to take on.
One thing I should probably actually look into is the actual best option between 3M and 2y for the long portion. I current assumption is it ends up being a tradeoff between the rapidity of the response and the steepness of the shock drawdowns. Considering the big risk is getting blown out by a shock short-term surprise that inverts the curve more, I settled on 10y-2y to soften that risk, but again I've got no in-depth analysis to back that up.
That being said, I'm spending more time nowadays trying to understand why the federal reserve isn't using their MBS sales to control shelter inflation separately from broader interest rates - so far that's yielded unsatisfactory answers about how the correlation is very low using methodologies I disagree with so I've been spending spare time looking into econometrics so no promises I'll be pushing this steepener theory myself, but I'll engage here if people are interested.
It seems like this things have been pretty slow here recently, so I hope this provides some more food for thought!
Statistics: Posted by SongOfTheFates — Thu Jun 27, 2024 2:48 am