Since I have been posting about curve trades and treasury future butterflies in the chat recently, I’ve gotten a few of questions about how/why to implement them. While they’re certainly a strategy that should be employed by more sophisticated investors, understanding the yield curve is an essential part of understanding the significance of bond market signals that apply to the broader economy and curve trades can provide payoffs for specific economic scenarios that are hard to find elsewhere.
If you’re already a paid subscriber that knows how trading the curve works, skip to the end for an update on the position mentioned in the chat back on July 14th.
So, with that said, I’d like to introduce you to the first installation of my series:
Global Macro Trading for Idiots
Part One: Trading the US Yield Curve
Playing shifts in the shape of the yield curve can be an excellent way to express your view on the economy and the monetary/fiscal response to it without having to worry about idiosyncrasies in markets like commodities or stocks. In order to do so, there are a few things you need to understand:
The way the yield curve moves in response to various economic, monetary and fiscal developments
The relationship between price and yield across various durations of treasuries (called “tenors”)
How to ensure you are actually playing the curve in a manner that results in your PnL moving a set amount for not the changes in individual bond yields but rather the change in the value (measured in basis points) of the yield curve.
Once these things are known, it’s relatively simple to add a new strategy to your repertoire that can present significantly asymmetric opportunities and afford you a dynamic way to hedge equity or commodity bets. Since this is the first installment of “macro for idiots”1, I will not be going into things like carry, roll, flys etc. The purpose of this article is solely for beginners to understand how these moves work and how to make use of them in understanding what signals the bond market is sending. It should also help investors understand why the signals sent by the yield curve have historically held significance in economic forecasts and why they may be wrong in unique situations.
Remember that the “normal” state of the yield curve is for there to be a “term premium” on longer durations, essentially a higher yield promised to investors for their willingness to lock up their money for longer periods of time and take the risk that interest rates may change during the duration of the bond.
So let’s look at a curve.
The above yield curve is “normal”. Banks borrowing short and lending long love it. And savers get rewarded with higher yields for locking up their money for longer. It works.
Keep this shape in mind when we’re discussing the curve, with one caveat. When we are talking about “steepeners” or “flatteners” in the context of the curve already being inverted, do not think of this shape or else you will get them backwards2. It’s much more simple to think of the curve when those terms are being used as a graph with the X axis being time (not duration) and the Y axis being the difference of [longer yield] minus [shorter yield].
This will become apparent later but just think of it this way: when someone says “yield curve” think shape and when someone mentions a *specific* yield curve, like 2s10s, think 10 year yield minus 2 year yield plotted like this:
If this line is going UP, it’s a “steepener”
If this line is going DOWN, it’s a “flattener”
So what’s all this “steepener” and “flattener” talk anyway.
Well, here’s what yields are right now:
And here’s a comparison of what the yield curve looks like right now versus how it looked 90 days in the past and 360 days in the past:
360 days ago, the yield curve was “normal”, then as you can see the yield curve now and 90 days ago is “inverted” or downward sloping. The extent to which the change increases the difference between the yields of the short vs long tenor determines whether it has flattened or steepened, and the overall direction the curve is heading in absolute terms (for example, here the curve currently has higher yields across all tenors than it did 90 days ago) determines whether the move is a “bear” or “bull”.
This is YIELD and THE PRICE OF A BOND MOVES INVERSELY WITH THE YIELD. Higher yields are bearish for bonds. Thus, this represents a “bear flattening”.
That means you would have made money over the last 90 days if you were either short bonds (any tenor, in this case, but specifically it refers to the tenors of the curve being referred to) or if you were selling short duration and buying longer duration
That’s not the case with the past 30 days! Check it out:
So let’s examine the 2s10s. I’ve drawn lines in blue to represent where the yields are today for 2yr and 10yr (dashed) and then in orange to represent where yields were in early July for 2yr and 10yr (dotted).
Ten year treasuries have sold off to the tune of nearly 38 basis points higher yields. Two year treasuries have also moved higher, but only by about 20 basis points.
The past month has been bearish for rates in both tenors. (Yes, even though interest rates are higher, the terminology that’s used and that you should use so you can speak about this stuff is higher yields = bearish rates and lower yields = bullish rates).
What’s the direction of rates across this curve?
Well, both of the differences are positive. So the move has resulted in higher yields, therefore we know it is a “bear _something_”.
Now for the second part. Has the curve moved in the direction of longer term yields being higher than shorter term yields?
We just subtract the move in rates for the shorter tenor from the move in rates for the longer tenor:
So that means the curve is steeper. Over the past 30 days, in the US 2s10s yield curve, there has been a bear steepener.
Fun, right?
Now let’s get into...