in dwelling upon last week’s sterilized QE 3 leak in front of this week’s FOMC we couldn’t help but notice the 2YR yield has broken above its most recent range and is the highest level since the August flight to quality bid took yields to record lows. With the ZIRP pledge to 2014 and the selling of 2YR to finance the Fed’s Operation Twist (OT) curve extension trade the 2YR yield has been grinding higher ever since the September lows at 15bps when OT was announced.
While the 2YR yield seems to want higher taking out the 30bps level the 10YR yield remains locked into the range it has traded since October. In fact, the 2s/10s curve has been confined to a tight 20bps range that has averaged ~170bps basically where it settled Friday. That range has basically consisted of a 2YR straddling .25% and a 10YR 2.00%.
With the 2YR pressing for the 40bps level where it traded pre-Aug equity crash the curve should be biased toward the flatter side of the 2s/10s range near 160bps, however from there it gets tricky. The market seems to be largely long the front end of the yield curve while the Fed is primarily been buying the back end thus keeping the curve relatively flat and balanced since Operation Twist began.
With the Fed focusing on the long end and with the the economy improving and stock market poised to break out to new highs the demand for liquidity in the front of the yield curve diminishes as capital becomes more long term focused. As real money rotates out of liquidity and as the Fed continues to remove supply in the long end the curve should continue to flatten which could drive some intense pressure in the crowded front end. We have recently read where implied volatility in the front end has drifted to levels exceeding actual volatility as the market discounts ZIRP thru 2014 and thus no reason to hedge. If the 2YR continues towards .40% and can take out that level those short volatility may be forced to cover driving a spike in imp vol. There are a lot of long fixed income positions that are short volatility via callable optionality and if the curve starts working on a bear flattener trend it could create some curve “intension” putting pressure on low coupon long duration negative convex positions…