Here’s how investors can profit from the debt ceiling deadline: BMO

Posted by jbrumley on September 5, 2017 11:00 AM
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- BMO Capital’s Lyngen and Kohli eye a steepening trade between the 2-year and 5-year Treasury note -

By Sunny Oh, MarketWatch

For market watchers, the government’s debt ceiling deadline is a ticking time bomb forcing some to rethink their portfolios.

Concerns that an 11th-hour resolution will fail to materialize has drawn concerns of a government shutdown, and a potential loss of the U.S.’s gold-plated triple-A credit rating.

Now with President Donald Trump warning at a rally in Arizona last week that he may be willing to let the federal government go dark if he does not get some policy demands, what was once considered a long shot has grown more likely in the minds of investors.

Regardless of the debate outcome, Ian Lyngen and Aaron Kohli, fixed-income strategists at BMO Capital Markets, suggest that speculators place a so-called steepener trade—a bet that shorts the 5-year Treasury note on the belief its yield will go higher and simultaneously goes long on the 2-year Treasury note, on the belief its yield will drop.

If the yield curve—which charts the range of interest rates, or yields, along a maturity spectrum—does steepen, these trades would benefit.

Their bet is built on two pillars of reasoning. First, “the Treasury Department will rapidly cut bill supply as we approach the debt-ceiling deadline. This should induce front-end buyers to grab for yields further up the curve.” Second, “the Treasury may delay actions, starting with the very front-end (bills) and eventually moving to the coupon auctions.”

This will lead to a “successive steepening and then subsequent flattening of the curve” at the front-end, before moving onto longer-dated notes like a row of dominoes falling on one top of another. Once this wave of steepening finally arrives between the 2-year and the 5-year note, traders can cash out.

The same phenomenon took place in 2013 (see chart below), when the Obama administration struggled to hash out a deal with Republicans to hike the government borrowing limit.

”The pattern of outright yield moves shows that investors took 3-month bill rates to zero (avoiding issues maturing around the time of the debt-ceiling ‘drop-dead’ date) and then moved on to 6-month bill rates, which subsequently fell to zero as well,” the strategists said.

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The yield spread between the 3-month bill and the 1-year note, one gauge of the yield curve’s steepness, narrowed and then widened.

Amar Reganti, a senior fixed-income strategist for Grantham Mayo Van Otterloo & Co. and a former Treasury Department official, admits the assumption behind the strategy is sound.

“As the Treasury Department starts to approach the x-date, what’s going to happen is that they’re going to cut bill issuance in order to stay within the debt limit,” he said. “Instead, they will run their cash on hand. The first place they tend to cut issuance is the very front end of the curve, particularly in the bills markets.”

“To some degree, it’s not crazy that would cause some steepness,” he added.

But Reganti points out there is one way the trade could fall flat. If the debt ceiling issue is resolved sooner rather than later, the government will begin “ramping its issuance as it needs to start refunding its own cash balance. There’ll be a lot more anticipated supply later in the year,” he said.

Lyngen and Kohli concede that if the Trump administration and Congress make progress on the debt ceiling deadline earlier than expected, it could put their wager into the red.

And now, the growing damages from Hurricane Harvey could exert pressure on Congress to raise the government’s borrowing capacity earlier than expected, if a Harvey relief bill is attached to the deal.

Even if all the pieces do fall into place, geopolitical concerns can easily overwhelm the trade and flatten the yield curve. The BMO strategists said three weeks ago their steepener was out-of-the-money. That is, investors would have lost money if they had left the strategy.

At that time, sharp swings in political uncertainty drove bond prices higher after a standoff between North Korea and President Donald Trump’s administration. The war of words eventually cooled, only to give way to another development that put bonds in favor, uncertainty that a Trump pro-business agenda stood a chance in part because a handful of executives were leaving his business advisory panel in frustration.

The end result? Falling yields that hammered the curve flat.

From MarketWatch

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