Top Trade Update – Short US Government 10 Year Bonds

3 December 2015

Federal Reserve On The Move
A month on from the initiation of our short US 10 year government bond trade, we review the trade and
assess its credentials. still favours the US Federal Reserve to increase interest rates in December by
0.25%. The market has come more in line with our core view and as a result this has seen bond yields climb
some 20 basis points, from 2.028% to 2.232%. We believe all points in our investment these still hold and
therefore continue to believe that bond yields will continue to go higher in yield.

believes the US Federal Reserve will increase interest
rates in 2016
US unemployment is very low
Opening Price
The federal Reserve has told the market they anticipate to
Current Price
increase interest rates this year
Date opened
27 Oct 15
We are sold a US 10 year bond at 2.028% it is now at
Profit/Loss Realised
20.4 bps
2.232% a gain of 20.4 basis points

The value of the trade will increase as US yields go higher

Selling US 10 Year Government Bond

Over the course of the past month, interest rate yields in the US have increased by 20.4 basis

points from 2.028% to 2.232%. The 10 year reached as high as 2.342%, but have since retracted


The push higher in bond yields has largely been led by the market becoming more comfortable
with the fact that the Federal Reserve is likely to raise interest rates in December. The key US
unemployment figures continue to demonstrate that the US economic recovery is strong. In
addition, concerns round global growth and a hard landing for the Chinese economy appear to
have abated and this is assisting in yields going higher.
Low inflation remains the only major concern for this trade, however we have seen a
stabilisation in energy prices (a key determinant of US inflation) which may help to increase the
inflation rate over time. If we to observe a material increase in the inflation rate we would see

27 November 2015

a material increase and bond yields as the Federal Reserve may be forced to increase interest
rates faster and by more than they currently anticipate.
Consequently, we continue to strongly believe in the investment case for selling US 10 year
government bonds. Economic data continues to point to a strengthen US economy and it
appears that the US Federal Reserve is comfortable increasing interest rates by 0.25% in
December. We anticipate that once interest rates begin to increase, they will continue to go
higher gradually over time.

Investment Thesis – Why we like it

The US federal Reserve Chairman Janet Yellen along with multiple other influential

Federal Reserve voting members have been very vocal in telling the public that they

anticipate that they will begin increase interest rates in 2015. Yellen’s Speech extracts

are below.

“It will likely be appropriate to raise the target range of the federal-funds rate sometime

later this year and to continue boosting short-term rates at a gradual pace thereafter
as the labor market improves further and inflation moves back to our 2% objective,”

“The more prudent strategy is to begin tightening in a timely fashion and at a gradual
pace, adjusting policy as needed in light of incoming data.”

The US unemployment rate continues to improve month to month currently sitting at
5.1% comfortably within the Federal Reserve’s target band of between 4.7% to 5.8%.
We believe entering a short position at 2.028% offers excellent risk reward. This level
is towards the bottom end of its historical range and therefore it has a lot of potential
to increase. believes that once the Federal Reserve begins increasing interest
rates they will continue to increase them gradually over time. We believe this will result
in the US 10 year bond yield continually increasing in yield.

27 November 2015

As illustrate in the chart above, we are able to observe the US 10 year bond yield
against the US equity market (S&P 500) dividend yield. This is a measure typically used
by investors to assess the relative value of holding a bond vs holding equities from an
income perspective. As we can see above, the bond yield (2.028%) is below that of the
equity dividend yield (2.19%). This means that investors receive more income from
bonds over equities at present. Accordingly, it does not appear like owing bonds is a
great value decisions.
A risk to this trade is that the US federal Reserve decides not to raise interest rates
because the economy’s inflation is too low. The current inflation rate is around 1.5%
and is below where the Federal Reserve what the rate to be. Federal Reserve Chairman
Janet Yellen says:
“Inflation is, as you mentioned, running considerably below our 2% objective.
Nevertheless, the committee judges that an important reason for that is the declines in
energy prices and the prices of non-energy imports,”

“But I expect that inflation will return to 2% over the next few years as the temporary
factors weighing on inflation wane.”

Clearly, the inflation rate remains a concern for the Federal Reserve, but they
anticipate the rate to raise above the target of 2% in the medium term future.
At the September Federal Reserve meeting, the recent global slowdown was
highlighted as the reason for delaying the start of their interest rate increasing cycle.
This mainly revolves around the slowdown in the Chinese economy. However,
believes that China is in for slow landing and therefore although it remains at the
forefront our minds, we don’t not anticipate this preventing the Federal Reserve from
increasing rates this year.
Geo-political risks are always a concern to any investment. If there was a period of
turbulence we would expect bond yields to decline as investor’s seek safety from other
riskier assets. As these events are impossible to predict, we don’t believe it is a major
risk factor in our investment thesis.

27 November 2015

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27 November 2015

Short US 10 year government bond update

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