Things are different now.
The largest factor in quantitative trading is being able to keep up with the times. Being too far behind can put you out of business, while being too early can test your mettle. So, as we are currently on the verge of a significant regime change, let’s see exactly how quantitative bond traders are adapting to the times.
Farewell, Rate Hikes
The major theme of 2022 and early-2023 was: “how aggressively will the fed raise rates?”. The market had been in a regime of near 0% interest rates for more than 10 years, so such a planned shift offered traders an opportunity to get in early and bet big.
Naturally, this led to a few home runs:
We addressed exactly how they did it here: Bond Trading Is More Profitable Than You Think… Like, Way More.
However, what goes up, must come down — or at least stay flat.
With interest rates currently (as of September 2023) at ~5.50%, the market is starting to anticipate that we’re at a peak, and that a significant trading opportunity exists — much like the one in 2022.
But before we dive into the strategy, let’s first get some data to back this up.
The FedWatch Tool
If we want to get a heads up on where the bond market is going next, there’s no better place than the CME FedWatch Tool:
There are essentially 2 pieces of data that will give us the heads-up we need:
The implied probability feature represents the probability of a fed decision in the next FOMC meeting. For example, we can say that the market implies a 93% probability of rates staying flat in the next meeting.
To calculate this, we first have to get the fed funds rate that the market implies. To do this, we need the price of the 30-day fed funds futures:
To get the implied rate, we subtract this price from 100:
Implied Fed Funds Rate = 100–94.63 = 5.37%
This real-time implied rate is then converted to a probability as follows:
Since there are multiple futures contracts with expiration dates in the future, we can take an even further look ahead to see what the market anticipates will happen to rates in 2024:
As demonstrated, the market currently implies that in exactly 1 year from now, in September 2024, the fed has a 96% probability of lowering rates, with the main expectation of rates to be around 4.50–4.75%; almost a full percentage point lower. You can see the full range of probabilities here:
So, we’ve got the first confirmation that overall, the market is betting that rates will remain flat for a few more months, then will decrease.
Now, let’s get an estimate straight from the lion’s mouth:
Connecting The Dots
Instead of just relying on current prices, we can take the estimates of actual FOMC officials on what they estimate rates to be across time. To do this, we will refer to the “dot plot”:
As demonstrated, there is a strong downward trend in estimates of where officials estimate rates to be.
So, now that we have a solid basis for thinking that rates will go down, it’s time to make some money.
The fed funds rate is a proxy for short-term interest rates, so as those rates decrease, the prices will increase. Lowering short-term rates is known to boost economic growth and increase inflation, so to compensate for this, longer-term bonds will see an increase in yields. As the long-term rates increase, the prices will decrease.
Buying short-term bonds (or futures) and shorting long-term bonds are known as a bull steepener trade.
To see why it’s called that, let’s take a look at this graphic:
The x-axis represents time to maturity, with the y-axis representing yield. This is what’s known as a yield curve.
In the bull steepening example, the bonds at the front of the curve with early maturities (<2 years) decrease yield at a higher rate than those at the back of the curve with higher maturities (>10 years). This makes the curve steeper — hence, a steepener trade.
Currently, this is the rainmaker trade for late-2023 to 2024, and Wall Street knows it:
So yeah, calling this the hottest trade of the year is an understatement.
If this article piqued your interest, you’d definitely enjoy some of my other posts just like this one:
- Turbo-Charging The ARIMAX Option System [Code Included]
- Kick-Off! Quasi-Arbitraging NFL Markets [Code Included]
- Hunting Down an ETF Arbitrage
Happy trading! 😄