Butterfly yields, or the difference between the five-year Treasury and the average of the two- and 10-year varieties, have fallen steeply over the past few months as five-years have rapidly outperformed.
Overall, the butterfly yield has fallen from 30 basis points to minus 2bps over the past few months as five-years have been popular among investors.
Joseph Shatz, senior government strategist at Merrill Lynch, attributed the steep fall in the butterfly yield to a disconnect between the market's and the Federal Reserve's view of the economy.
While the front end of the yield curve has been rising due to Fed Funds increases, the five-year and the back end of have stayed stable or rallied because the market doesn't believe the rate increases are necessary, Shatz said. "The market definitely does not have as optimistic a view on the economy as the Fed," he said.
The butterfly yield reached a low of around minus 7bps in November 1998 and a high of 48bps in December 2001. As a result of the recent activity, Merrill recommends its clients short five-years and go long on twos and 10s.
