More Rate Hikes on the Menu

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CBOT: Micro 30-Year Treasury Yield ( 30Y1!)
President Biden and House Speaker Kevin McCarthy reached an agreement in principle late Saturday to raise the nation’s debt limit and cut federal spending, ending a rollercoaster round of negotiations.

The current national debt ceiling is $31.4 trillion. The tentative deal would raise it by $4 trillion through the end of 2024. In return, it would cap annual discretionary spending for two years, keeping non-defense spending levels flat.

Future Fed Rate Actions
With a US default and potential economic disaster being averted, the Federal Reserve (Fed) would likely stay on its course of fighting inflation.

On May 26th, the Bureau of Economic Analysis (BEA) reported the Personal Consumption Expenditures Price Index (PCE) up by 0.4% in April to an annual rate of 4.4%.

• This surpassed both the market consensus of 3.9% and the March PCE of 4.2%.
  
• The Core PCE excluding food and energy is 4.7%, exceeding March level by 0.1%.
  

The surprising rebound in inflation indicates that the Fed’s job is not done, even after it hiked the Fed Funds rate seven times last year and three more times in 2023.

CME FedWatch Tool gauges the probabilities of rate hikes based on 30-Day Fed Funds futures pricing data. It shows that, on May 28th, the odds of a 25-bp hike in June FOMC meeting at 64.2%. The probability of raising another 25 bps in July is 27.1%. The futures market does not expect the Fed to cut interest rates before the end of the year.

The interest rate market is in disarray, and this may present new trading opportunities.

Mortgage Rate Tops 7%
On Sunday, May 28th, the average 30-year fixed mortgage interest rate is 7.15%, rising 16 basis points from last week, according to Bankrate.com.

• This is an annual increase of 1.61%: the 30-year fixed was 5.54% on May 26th, 2022;
  
• Prior to the Fed rate hikes, it was only 3.65%-3.85% in February 2022.
  

MORTGAGE30US, the mortgage rate data tracked by the Federal Reserve Bank of St. Louis, records 6.57% on May 25th. Meanwhile, CBOT 30-Year Micro Yield Futures is quoted 3.988% for its May contract last Friday. What does this mean?

The 30-year duration interest rate spread between the riskless Treasury rate and a risky mortgage rate is now 258 basis points.

• For comparison, in September 2021, the same spread was only 80 bps with a 2.1% Treasury yield and a 2.9% mortgage rate.
  
• The spread has more than tripled in the past two years.
  

When the Fed started raising rates last year, both Treasury yield and mortgage rate rose. The trends diverged in October. In the mortgage market, banks continued to raise lending rates in response to the actual increases in the cost of capital.

In the financial market, “Fed Pivot” expectations weighed on Treasury prices. As the Fed lowered the rate increases from 75 bps to 50 bps and then 25 bps, 10- and 30-Year bond yields fell, while 1-Month and 2-Year yields rose, creating a negative yield curve, or the so-called inverted yield curve.

Why Treasury Yield Needs to Catch Up
In hindsight, mortgage bankers are proven to be right, while the rate cut forecast by bond investors is premature. With the new twist in inflation data, both bond yield and mortgage rate have the potential to go up further in the coming months. Treasury bond yield has some “catching up” to do as investors adjust their expectations.

Here is my logic:
Firstly, raising the debt ceiling opens up trillions of dollars of new government borrowing. By the rule of supply and demand, a high demand of money will raise its price, all else constant. Treasury bond yield is the price the government paid to borrow money;

Secondly, the last-minute deal on debt ceiling helps avoid a potential economic crisis. The housing market is cooling but unlikely to crash any time soon. This ensures that the higher mortgage rates are here to stay;

Thirdly, the large interest rate spread created an arbitrage opportunity for lenders by borrowing from the bond market to fund the mortgage operations with the same maturity;

Therefore, the 30-year Mortgage-to-Treasury spread could narrow in the future. Since mortgage rate is not likely to fall, the gap could be closed by a higher Treasury yield.

We could express the view of high Treasury yield expectation by establishing a long position in CBOT 30-Year Micro Yield Futures. The June contract 30YM3 is quoted 4.000% last Friday. Each contract has a notional value of 1,000 index points, which equates to $4,000 at current quote. CME Group requires an initial margin of $300 per contract.

Current Fed Funds target rate is 500-525 bps. Hypothetically, if the Fed raises 25 bps in June, and 30-Year Treasury Yield goes up by the same amount, a long futures position could gain $250. This would be equivalent to an 83% return, excluding commissions.

Long Futures would lose money if the yield falls, by $10 for each basis point movement.

The July contract 30YN3 will begin trading this week. I would monitor the opening price to determine if it is still quoted at a discount - below short-term Treasury rate and mortgage rate.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/