Yield Trends in Treasuries

Examining the mean-reverting and trending properties of butterfly trades in the Treasury market

Hello!

Welcome back to another paid post. Today, we will be diving deeper into the U.S. Treasury market, by examining Butterfly trade structures.

As I’ll show, there are remarkable statistically significant patterns in this market.

Let’s get into it.

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Bond Investor Expectations

Before we go into my own analysis, AQR has an interesting paper on bond investor expectations. Data shows that bond investors are naturally contrarian. They usually expect mean reversion, meaning if rates have been falling, they bet on them eventually rising back to a “normal” level. Because bonds are quoted in yields (which are forward-looking), investors tend to focus on where rates should be rather than just following the recent price trend.

However, this contrarian mindset hasn’t actually matched the data over the last two centuries. Historically, bonds have actually shown positive decadal autocorrelation, with a correlation of +0.5 since 1800 and +0.6 since 1900.

This means that bond returns have tended to continue in the same direction over long periods rather than reversing. You can see the forecasts of bond investors during various historical periods below.

Expectations are clearly mean reverting

Despite this historical trend of continuation, experts and the market have stuck to mean-reverting expectations. This led to the “folly of forecasting” seen from 1981 to 2021, where economists repeatedly predicted rate hikes that never happened as yields drifted lower for 40 years.

While these expectations of a reversal made sense at the time, they were consistently beaten by a secular downtrend that most observers now believe has finally reached its limit.

As we will show below, bond yields do not always exhibit mean reversion (even on short time periods!).