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Trading Yield Curve Shifts with Treasury Futures

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March 3, 2015
Skiing the slopes

Trading the slope of the yield curve using Treasury futures is a little like skiing the slopes of Utah. Steep or flat, there’s something for everybody. Just remember, when the slope changes, it can change fast.

The yield curve represents  yields across several maturities ranging from short term (1 month) to long term (30 years). In its “normal” state, the yield curve is positively sloped, or steeper, where the yields of longer-dated maturities are higher than shorter-dated ones. Yields are higher to compensate investors for the longer exposure. The reverse can be true, too, leading to an inverted curve.

Traders who are eyeing Treasury futures moves against the curve care less about the direction that interest rate yields move, and more about the difference in yield. Understanding difference in yield can potentially generate returns for your portfolio.

The slope of the yield curve is basically the difference between the longer-term yield and the shorter-term yield. One of the more popular relationships to track is the difference between the 10-year Treasury note and the 30-year Treasury bond, known as the notes-over-bond (NoB) spread and denoted as 10s30s.

Current Conditions

In simplified terms, if economic conditions are improving (as we see currently), the yield curve tends to steepen. If economic conditions are deteriorating, the yield curve flattens. Pretty simple, right? It’s worth emphasizing that trading the slope of the curve is different from trading the level of the curve.

The yield curve, as measured by the 10-year and 30-year Treasuries, flattened significantly in the last 15 months. Several factors combined to push the longer-term bond yields down (they move inversely to price) at a faster rate than shorter-term bonds. Those factors include the Federal Reserve’s quantitative easing bond-buying program, slowing global growth, and currency volatility. The last time the yield curve looked this flat was before the financial crisis in 2007 (figure 1).

10-year and 30-year Treasury moves versus yield curve

FIGURE 1: WHAT CURVE? “Curve” may be a misnomer, as this chart from early February compares 10-year and 30-year Treasury moves (upper view) to the flattening “curve” or spread (lower view). The economy may be perking up, which would typically steepen a yield curve, but global demand for U.S. bonds hasn’t fallen off. Is this curve due for a bounce? Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Here’s the bottom line: If you believe economic conditions will improve, the yield curve is likely to steepen significantly from this level and it’s better to buy the 10s30s spread. If you believe economic conditions will deteriorate, the yield curve is likely to flatten further and it’s better to sell the 10s30s spread.

Constructing a SampleTrade

The yield curve spread includes two legs: the front leg, which “drives” the direction of the spread, and the back leg. For the example in figure 2, we’ll use the NoB spread of 10s30s, but other popular spreads include the 2s10s and the 5s10s.

Hypothetical two-legged spread trades.

FIGURE 2: LET’S EXPERIMENT. Hypothetical two-legged spread trades. For illustrative purposes only. Past performance does not guarantee future results.

Note how the contract quantities are different for each instrument. The quantity for the perfect hedge ratio can be tricky because it’s based on the dollar value of a one-basis-point change (DV01), which is different for each instrument and changes dynamically. The CME provides an updated table with the most recent figures.

Don’t sweat trying to calculate precise hedge ratios that produce a perfectly neutral DV01. It’s often impractical and expensive to maintain while the trade progresses.

Most spread traders live with the fact that the trade is capturing 90–95% of the change in the curve, while the rest is exposed to some directionality of interest rates.