If You Thought The Yield Curve Was Steep Now, Then You Haven't Seen Anything Yet

(This guest post comes courtesy of The Mad Hedge Fund Trader)

Make no mistake. The shot has been fired across the bow, the chink has appeared in the armour, and the crack has opened up in the dike. The Fed’s move to raise the discount rate on Thursday from 0.5% to 0.75% may have been technical, widely telegraphed by the Fed minutes, and an unwind of an artificial spike down in rates the economy no longer needs. Sure there was only $15 billion in loans outstanding at the Fed window, against $1 trillion in excess bank reserves. But it was definitely an UP move for rates.

The liquidity tide that has been floating all asset boats has reversed and is starting to recede. We’re about to find out who has been swimming without a swimming suit. The train is leaving the station. Next week the TALF expires, eventually sucking another $1.5 trillion out of the system. The Fed is reverting from its role as the lender of first resort back to its traditional role as the lender of last resort. Inflationary expectations are going to rise.

While overnight rates are going to remain minuscule, probably for the rest of the year, the long end is going to take this less well. That means that one of the steepest yield curves in history is about to become a lot steeper. I’m thinking the face of Half Dome. Now I know that I have been predicting that a short in 30 year Treasury bonds will be THE great trade of 2010. But don’t pop the champagne bottles just yet. Without more aggressive Fed action, the rise in long rates is unlikely to be a sudden, panicky spike. 

So while you can comfortably sit with non leveraged short play like the TBF, you are going to have to nimbly trade the leveraged ones like a demon, such  as the TBT, to keep the cost of carry from eating you alive. You are still sailing upwind against a 4.7% yield, and you can multiply that with leverage.

Think of it more as a slow ground offensive, than a lightning fast aerial assault. But it will grind us inevitably closer towards a major triggering event that will bring real fireworks, my favourite being a failed Treasury auction. If your spouse has a divorce lawyer pounding on your door unless you buy a house tomorrow, make sure you do so with a 30 year fixed. It will be the last time you see sub 5% mortgages rates in your lifetime. Better yet, dump the spouse.



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