It’s not just the Fed that is adding volatility to the Treasury market and the yield curve, a combination of other factors are also behind the fluctuation. Currently, the short end of the yield curve is rising faster than the long end, and the spread between both is narrowing.
In fact, the yield curves are near the flattest levels in a decade. From the start of this year, the spread between two-year and 10-year yields shrank 53 bps to 72 bps, two-year and 30-year yields shrank 68 bps to 119 bps, five-year and 10-year narrowed 19 bps to 33 bps and five-year and 30-year contracted 24 bps to 80 bps (read: Junk Bond ETFs Plunge to Seven-Month Low).
The trend is likely to continue given that the recent rounds of upbeat economic data are fueling further spike in yields, especially the short-term ones. The U.S. economy has been accelerating with GDP expanding at least 3% year over year in the second and third quarter, representing the best back-to-back quarters in three years. Unemployment dropped to the lowest level since December 2000 to 4.1%. Americans also have an optimistic view of the economy with confidence hitting the highest level in almost 17 years. Meanwhile, consumer spending, which accounts for more than two-thirds of U.S. economic activity, recorded its biggest increase in more than eight years in September.
Additionally, the prospect of a third rate hike in December is boosting short-dated yields. Per CME Group, there is 97.7% probability that the central bank will announce a lift-off on December 13. On the other hand, tepid inflation is putting a cap on the rise in longer-dated yields.
If these weren’t enough, uncertainty or delay in the tax reform plan is seen as one of the factors that could further flatten the yield curve (read: Value ETFs & Stocks to Buy on Tax Cut Delay Concerns).
Given that the yield curve is flattening, investors should avoid riding on the yield curve or take inverse position. This could be easily be done through the only option in the broad bond ETF space – iPath US Treasury Flattener ETN (FLAT - Free Report) .
FLAT in Focus
This product provides inverse (or opposite) exposure to the Barclays US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts. The index takes a weighted long position in 2-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. It generally rises when the yield curve steepens and falls when flattened. As such, investors could make smart profits from the flattening of the yield curve through the ETN thanks to its inverse relation with the index.
Though FLAT charges 0.75% in expense ratio – a modest fee in inverse bond space, it has a higher trading cost thanks to its illiquid nature. The note trades in volume of less than 1,000 shares a day on average. It is unpopular too as it has amassed just $3.5 million in its asset base.
The note has gained nearly 1.3% in a month and clearly outpaced the broad U.S. market fund (SPY - Free Report) and the ultra-popular short-term bond (BSV - Free Report) by wide margins. The outperformance might continue in the weeks ahead given that a December interest rate hike is in the cards and the inflation outlook is weak (see: all the Government Bond ETFs here).
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