Heading into next year, tighter monetary policy and a deceleration of economic growth are likely to present a more challenging environment for risk assets. In rate of change terms, economic growth as measured by U.S. Y/Y Real GDP is likely to slow against very steep base effects, returning to a level reminiscent of our pre-COVID economy.
U.S. Real GDP Y/Y
Additionally, should the robust recovery in the labor market continue, it is also likely supply chain linked inflationary pressures will start to subside into the first half of 2022.
U.S. Weekly Jobless Claims 4-Week Average
U.S. Unemployment Rate
U.S. Headline CPI Y/Y
Should the economy enter a period where both the rate of change of economic growth and inflation inflect to the downside, coupled with a Federal Reserve embarking on a path towards raising short-term interest rates, we could see longer dated treasuries outperform amid a further flattening of the yield curve and tighter financial conditions.
Said differently, I believe the Fed will find itself tightening into a slowdown, which could be presaged by a bullish flattening of the yield curve. This scenario involves falling long-term rates, while the short end of the interest rate curve remains anchored to current expectations of 3 rate hikes in 2022.
The market may be signaling this trade is already underway when we look at the 2s10s curve. Should it pick up momentum, I believe we could see further compression towards 0.50%.
U.S. Treasury Yield Curve 2s10s Spread
This trade can be expressed through a 2s10s bull flattener where we are short the 2 Year Treasury against a long 10 Year Treasury on a DVO1 (dollar value per bp) basis.
In simpler terms, this can also be expressed through bullish exposure to long dated treasures via options, futures, or Treasury ETF (Exchange Traded Fund) such as TLT.
— Written by Ryan Grace, tastytrade Chief Market Strategist