Curve Steepening

Something unusual is happening in Treasuries during the middle of a tightening cycle.  The 5-30s spread is increasing, not decreasing.  This usually only happens at the tail end of a tightening cycle when the market can see the end of rate hikes and is anticipating lower Fed funds rate in the future.  If that was the case, the Eurodollar and Fed funds futures markets wouldn't be pricing in 3 more 25 bp rate hikes through the end of 2019. 

6/13/2018 (Fed raises from 1.5-1.75 to 1.75-2.0%):   5 yr 2.85, 30 yr 3.10 (25 bps)
9/26/2018 (Fed raises from 1.75-2.0% to 2.0-2.25%): 5 yr 2.96, 30 yr 3.19 (23 bps)
11/09/2018: 5 yr 3.05, 30 yr 3.40 (35 bps)

Equities have not traded drastically lower, at least not enough for the market to reduce rate hike forecasts for the next 12 months.  So what is going on? 

1) Long end supply.  The Treasury is issuing more long term debt, and there is less willingness for dealers and fund managers to take down duration during a continuing bear market.  The size of 10 year auctions has gone from $20B in January to $27B in November, and the size of 30 year auctions has gone from $12B to $20B in the same time. 

2) There have been bond fund outflows over the past few weeks and that usually hurts the long end more than the short end. 

3) The curve flattener trade was very crowded and the equity market weakness in October caused liquidations of a favorite hedge fund trade. 

4) Bond fund managers feeling the heat from a negative year don't want to take duration risk and are content to just clipping coupons in short term Treasuries. 

5) The long end was overpriced relative to the short end.  With trillion dollar deficits as far as the eye can see, investors are now demanding higher rates for long term bonds with so much supply coming down the pipeline.

I expect the curve steepening to continue as I don't expect equities to be strong enough in the coming months, making it tough for the Fed to be more hawkish than expected.  Also, the sheer supply of Treasuries that will need to be taken down by investors is going to weigh on the long end more than any other part of the curve.  Int this part of the business cycle (late), without the Fed gobbling up long end supply, it makes it harder for the 30 yr part of the curve to outperform the short end. 

We got a bigger pullback than I expected on Friday, and it seems like the post mid term elections move higher was just a massive short squeeze/FOMO event.  We are back to reality now and it is not pretty.  I am long and missed the exit window, but I can objectively say that this is not a good situation for longs.  The upside will be limited, and although the market should grind higher in November, with each passing day, it gets more dangerous holding longs, as a retest of October 29 lows within a few weeks is not out of the question.  Still short term bullish for the next 2 weeks, but lower my price targets.