Bond Butterfly Shows Fed in No Rush After Dec. Liftoff: Analysis

All signs point to expectations for a dovish hike

While the much-anticipated U.S. interest-rate increase may well happen next month, the bond market doesn’t seem convinced a major tightening cycle is about to begin, Bloomberg strategist Tanvir Sandhu writes.

Three-year Treasury yields are near the highest since March versus a basket of two- and five-year rates in so-called butterfly trades, a sign that the market is positioning for the risk of the Federal Reserve will adopt a path of slow, spaced rate increases.

Charts show the spread in such a strategy tends to narrow when the market braces for a tightening of monetary conditions, and widen when the outlook turns relatively dovish. For example, the gauge reached the narrowest in about 2 1/2 years in December 2013, when the Fed was preparing to taper its asset-purchase program.

The 2013 tightening was largely driven by a selloff in five-year Treasuries. In contrast, the recent widening came about as the two- to three-year spread increased even as the three- to five-year section was relatively stable. That shows scaled-down expectations for longer-term rate increases, even as an imminent rise seems priced in.

Rate futures currently price a 68 percent chance of a December rate increase with three total rises seen by the end of 2016. The two-year Treasury forward curve is pricing in fed funds rate at 1.56 percent, no higher than the average of past three years and below 2014 highs. That level indicates about five rate increases, or about 140 basis points, over two years. The short end of the yield curve, barometer for interest-rate expectations, is watched closely by investors.

2015 vs 2013

A regression analysis of the butterfly spread, which traders term “the fly”, below shows how its different parts pulled it in opposing directions in 2013 and 2015. That shows that, even though both the years saw a general buildup of policy-tightening expectations, there’s a difference in the intensity of such anticipation.

The current sentiment seems relatively dovish compared with late 2013 even as the market braces for first rate rise since 2006, and that means expectations for the so-called terminal rate are being scaled down. The terminal rate is the highest level to which the Fed is expected to raise its benchmark in a given tightening cycle.

Five-year Treasury yields, which correspond to the terminal rate on the fly, have risen just three basis points this year, compared with a 102 basis point jump in 2013. The regression analysis shows that, in 2013, five-year yields had the strongest correlation of minus 0.89 to daily moves in the butterfly. In 2015, that link is the most compelling for two-year yields, at 0.48.

Butterfly outlook

Even if the Fed hikes in December, a dovish guidance from the central bank on the future rate path could cause Treasury forwards to price a lower terminal rate. Pricing for more gradual tightening beyond three years may see the three- to five-year part of the butterfly flatten as the market continues to price for a lower terminal funds rate, widening the fly spread further.

A low-for-longer rate stance by the Fed may cause the fly to trade inversely to rates as seen in prior periods. Should Fed Chair Yellen sound longer-term dovish before the Dec. meeting, two- and five-year yields could move lower than the three-year rate, boosting the fly further.

Key event risks into FOMC include Yellen’s speech on Dec. 2, the European Central Bank’s policy review on Dec. 3 and U.S. jobs data on Dec. 4.

Note: Tanvir Sandhu is a strategist who writes for First Word. The observations he makes are his own.

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