Wednesday, November 22, 2006

More on me being wrong

A post about being wrong. My wife would love it.

Several times in the last couple months I've made the case for a steepener. So far, so shitty on that bet. The curve has moved persistently more inverted since the end of September, now sitting at -18bps (2's vs. 10's), which is about the most inverted it got in February before making a big bear steepener in the spring.

Even though its painful to be wrong no matter what, at least part of my investment thesis is playing out (so far): that there was a limit to how inverted the curve could become. So having the curve go against me for ~20bps has a pretty nominal impact on relative return. I view my curve bet to be as much about the relative payoff as it is about the odds of a steeper or flatter curve. Consider the following:

1) Periods of curve inversion tend to be short, lasting less than a year. The curve has been inverted or nearly so for almost all of 2006.

2) The 20-yr average for the 2-10 slope is 90bps and the median is 69bps. The maximum (using month-end values) slope is +266, the minimum is -47.

3) The curve tends to steepen after the Fed starts cutting, usually flattening ahead of Fed cuts.

So we know that the inversion is already advanced in age and the upside for slope is greater than the downside. That makes a steepener a pretty good bet just based on risk/reward. If I'm wrong, and we get to the -50bps area in slope, that's only -30bps from here. If I'm right the median figure is +90bps from here.

The third point is the kicker for me. If the Fed starts cutting, there will be an initial period of inversion, followed by a severe steepener. If the Fed doesn't cut, then the curve will at least get back to a slope of +10 to +20 or so, because the inversion that now exists assumes some number of Fed cuts.

1 comment:

Unknown said...

Well, I'd argue that if the Fed doesn't cut, the market will simply expect them to cut next time. The Fed will not indefinately hold, a cut is due eventually. Meaning the inversion could stay for as long as the Fed maintains its holding pattern.