Rates Strategy Update: looking for flatter curves amid lower long-end yields

Last week's hot topic in the government bond area was the record-low short-end yields in the US with some T-bills trading at negative yields and also 2y UST yields back at the record lows of last December. The combination of lower policy rates for longer coupled with window-dressing by banks before year-end as well as a reduced issuance of T-bills is driving short-end rates lower. In turn, we have high demand by banks and by money-market mutual funds in an environment of shrinking supply. The outstanding amount of commercial paper is still only slightly more than half of what it was before the financial crisis started in mid-2007. Furthermore, in September, the US Treasury said that it was going to reduce the balance of its supplementary financing program, which was about $200 billion in September, to $15 billion. The SFP started in September 2008 and through this program, the Treasury sold T-bills to provide cash for use in Federal Reserve initiatives.
While I expect T-bill yields to remain low for an extended period amid limited growth and low inflaiton, the current levels will not prove sustainable into 2010 as the window-dressing goes into reverse.
However, while I regard the short-end of the US curve as too expensive, I still maintain my overall bond market bullish view as I look for lower long-end yields. On average, fundamental data has been surprising rather on the negative side as of late. Furthermore, while a week ago the technical picture appeared neutral, some bullish signals have been emitted in the meantime. First, the Bund future - while still trading below its early October high at 123.04 - has moved above the interim high reached on November 2 at 122.44. However, as cash bond yields remain stuck in their 3.20-3.40% range with 10y currently at 3.28% (and also the previous benchmark at 3.23%), the bullish signal is a weak one. In the US, the situation is similar. 10y futures have traded above their early October high of 119-29 on an intra-day basis, reaching 129-31+ on Friday before falling back. But in yield terms, the 3.30% level could once again not be broken and continues to serve as an important support area. Therefore, technically 10y bond futures look rather bullish, but yields remain in a neutral zone and the overall picture is neutral-to-bullish.
Positioning remains market supportive as short positions in US bond futures according to CFTC data increased even though they remain far from extreme. More importantly, the curve exposure rose ever higher amid larger longs in the 2y/5y segment and more pronounced shorts in the 10y/30y area. The current curve exposure (I used a pvbp-weighted measure, for further details refer to Beware of the Steepener dated November 16) is close to the all-time record and was only surpassed in between end September and end October last year (see chart below).

Curve exposure increased even further: warning signal for steepeners

Source: CFTC, Research Ahead

The combination of expensive short-end valuations coupled with an extreme curve positioning raises a serious warning flag for steepeners. I have already last week suggested that flatteners hold a more attractive risk-reward than steepening positions. And despite the position drive into the short end, the US curve failed to steepen over the past days and has remained range-bound. In the Eurozone, however, 2-10s on the Bund curve flattend by roughly 20bp since mid-November with all curve segments (i.e. 2-5s, 5-10s, 10-30s) showing a flattening tendency. So far, I do not think that this flattening movement is about to end and continue to expect flatteners to perform in the weeks ahead, in the Eurozone as well as in the US. This should largely be driven by long-end yields falling whereas short-end yields should remain range-bound (Eurozone) or even increase moderately (US).