The yield curve flattens—that is, it becomes less curvy—when the difference between yields on short-term bonds and yields on long-term bonds decreases. The skew for CDX.NA.IG.9 5Y shows negative spikes signaling a curve flattener trade. Phillips, who examined U.K. unemployment and wages from 1861-1957. Duration and Convexity Let's take a look at a common yield-curve trade, the duration-neutral bullish flattener between two and 10 years. 11.5k. One active trading strategy to take advantage of this scenario is to engage in what is referred to as a “flattening trade”. One macroeconomic scenario in which using a curve steepener trade could be beneficial would be if the Fed decides to significantly lower the interest rate, which could weaken the U.S. dollar and cause foreign central banks to stop buying the longer-term Treasury. A humped yield curve is a relatively rare type of yield curve that results when the interest rates on medium-term fixed income securities are higher than the rates of both long and short-term instruments. Specifically, under QE3, the Fed is actively buying treasuries with maturities of 2-10 years (to the tune of $85 billion of a month). Curve steepener trades benefit from rising yield differences as a result of an increase in the yield curve of two T-bonds of different maturities. The Trade War Has Sent the Yield Curve to Its Flattest Since 2007 By . TUT? This serves to lower those rates, given the increase in prices. Sometimes, the yield curve may be inverted or negative, meaning that short-term Treasury yields are higher than long-term yields. yields on long-term bonds are rising faster than yields on short-term bonds. Two primary yield curve spread strategies are the “flattener” and the “steepener.”. A yield curve is a graph of the bond yield of various maturities. Hedge funds jump in to cash in on the arbitrage opportunity,suffer … Liz McCormick. To account for this, the trade must be “duration weighted” meaning the amount of bonds traded must be adjusted accordingly. When incorporating this strategy, there are some important considerations to keep in mind. Here's an example. An inverted yield curve is the interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments. “The only trade to have on in the marketplace is the yield-curve flattener,” said Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings. The guys use the new Small Treasury Yield (S10Y) futures as their anchor for trading both 2YR-10YR (TUT) and 10YR-30YR (NOB) spreads. Click to see full answer. Posted by 6 months ago. Understand the structure and trading conventions of fixed income markets, and learn how to construct, interpret and trade the term structure of interest rates. Bear flatteners are typically structured using options. The difference between the short-term and long-term yield is known as the yield spread. What's it all mean?! ©2020 New York Institute of Finance. The strategy uses derivatives to hedge against a widening yield curve. For many active market participants, successful bond trading is not merely picking a point along the yield curve, and speculating whether interest rates will go up or down, but rather to speculate on the shape and slope of … Specifically, positioning yourself for the yield differential to narrow. A curve steepener trade is a strategy that uses derivatives to benefit from escalating yield differences that occur as a result of increases in the yield curve between two Treasury bonds of different maturities. Once they reduce or eliminate this intervention, we can assume that the yields on these maturities should rise, relative to longer maturities, such as the 30-year bond. As Matt goes on to point out, having a hedge against a “stress-loss” that involves the indices could well mean having a curve trade. As an example, in a bull flattening trade, you're betting that rates will decline AND the yield curve will flatten. Duration is … 160 Broadway 15th floor Additionally, whereas I used the cash treasury market to illustrate this potential opportunity, it can be utilized in other markets as well, specifically the futures market. The relentless flattening of the U.S. yield curve could be poised for a breather, as investors look for signs this week that escalating trade disputes will alter the … Traders and investors can, therefore, take advantage of the steepening curve by entering into a strategy known as the curve steepener trade. The curve may continue to flatten or invert, with or without a trade deal. Frank and Pete define yield curve spreads, and they show you how to trade them with ease. With the announcement yesterday by the FOMC that they will continue with QE3, the question once again remains: how long will they continue with this intervention? The Trade War Has Sent The Yield Curve To Its Flattest Since 2007. A bull flattener is a yield-rate environment in which long-term rates are decreasing more quickly than short-term rates. If the yield curve steepens, this means that the spread between long- and short-term interest rates increases—i.e. A par yield curve is a graphical representation of the yields of hypothetical Treasury securities with prices at par. Click here to download the course curriculum >. The first task in designing a yield curve trade is to decide how you expect the Treasury yield curve to react to interest rate developments during the term of the trade. Video/Image. However, active traders and participants in the bond market need to position themselves for “what’s next”. This strategy can be effective in certain macroeconomic scenarios in which the price of the longer-term Treasury is driven down. The carry of this trade would be much more complex - there will be carry from rolling down the yield curve, carry from time … A strategy that is employed by many such participants is “the flattening trade”. Specifically, a flattener. All Rights Reserved. The yield curve flattener has been one of the few consistent winners over the last few months. With the Fed’s target of 2.5% for inflation and 6.5% for unemployment, it appears that this intervention will not end soon. For the best experience on our site, be sure to turn on Javascript in your browser. My core trade on the yield curve is to be short, or underweight, the 3-7 year part of the yield curve and overweight 10-30, shaded toward 20-30. A steepening yield curve indicates that investors expect stronger economic growth and higher inflation, leading to higher interest rates. Some take a more subtle approach by trading spreads between, for example, CBOT Treasury futures to capitalize on changes in the shape of the yield curve. Tudor notes that curve flatteners provide 'tail risk insurance' against the trades of long gold, short the US dollar, and long equities. For more information on the New York Institute of Finance, visit the homepage or view in-person and online finance courses below: 90+ years of essential education for finance professionals delivered by leading industry experts. The risk measure for yield curve spread trades is DV01 (dollar value of a basis point). When the yield curve is steep, banks are able to borrow money at a lower interest rate and lend at a higher interest rate. Accordingly, they offer reduced initial margin requirements for a spread trade, when compared to outright buying or selling of futures contracts. If the yield curve steepens, this means that the spread between long- and short-term interest rates increases. Steepening? The current trajectory of the flattening in the US Treasury 5s30s curve (30y yield minus 5y yield) and the 10s30s curve (30y yield minus 10y yield) illustrates a potential for the following: 1) A flat curve by July 2018 if the flattening trajectory continues (green lines); 2)A flat curve by Nov 2018 if we plot the trajectory from the recent steepening of the curve (red lines). https://www.investopedia.com/terms/c/curve-steepener-trade.asp For example, an individual could employ a curve steepener trade by using derivatives to buy five-year Treasuries and short 10-year Treasuries. NOB? A curve steepener trade is a strategy that uses derivatives to benefit from escalating yield differences that occur as a result of increases in the yield curve between two Treasury bonds of different maturities. A bear steepener is the widening of the yield curve caused by long-term rates increasing at a faster rate than short-term rates. What flattening the curve actually looks like: During the Spanish Flu outbreak, Philadelphia held a parade while St. Louis cancelled public gatherings. New York, NY 10038. JavaScript seems to be disabled in your browser. This trade-off is the so-called Phillips curve relationship. The curve steepener trade involves an investor buying short-term Treasuries and shorting longer-term Treasuries. Close. The futures exchanges themselves recognize the more conservative nature of this strategy relative to an outright purchase or sale of contracts. When there is little or no difference between the short-term and long-term yields, a flat curve ensues. One of the benefits of this is the utilization of margin to further enhance risk/reward opportunities. A bear flattener causes the yield curve to flatten as short-term rates start to ratchet higher in anticipation of the Federal Reserve (FED) embarking on a tightening monetary policy. If it does the FOMC will be forced to ease monetary policy in order to support the U.S. economy. Let's say that on Jan. … With a history dating back more than 90 years, the New York Institute of Finance is a global leader in training for the financial services and related industries with course topics covering investment banking, securities, retirement income planning, insurance, mutual funds, financial planning, finance and accounting, and lending. This is a normal or positive yield curve. There are T’note and T’bond futures contracts on the CME that allow the speculator to incorporate this same strategy in the futures market. For the best experience on our site, be sure to turn on Javascript in your browser. By doing so, you are now not speculating on changes in the absolute level of interest rates, but rather the yield differential between these two maturities. But that bet on the so-called flattening of the yield curve may be in the nascent stages of reversal. Bull Steepener: A change in the yield curve caused by short-term rates falling faster than long-term rates, resulting in a higher spread between the two rates. For many active market participants, successful bond trading is not merely picking a point along the yield curve, and speculating whether interest rates will go up or down, but rather to speculate on the shape and slope of the yield curve. You will learn how to determine fair values, yields and risk measures for a wide variety of instruments including government bonds, corporate bonds, mortgage securities, and fixed income derivatives. As the back leg DV01 is greater than the front leg DV01, one must calculate a hedge ratio to result in a DV01 neutral position. This so-called flattener trade would pay off if the longer-term yield fell against the shorter one, relative to Sonia. Archived. The Excruciating Choice Governments face an “excruciating choice” between “flattening the (coronavirus) curve” by imposing quarantines and lockdowns and the huge, unprecedented economic impact on the world economy that is already in recession. When yields are rising, the yield curve will flatten. In general, when yields are falling, the yield curve will steepen. Phillips found an inverse relationship between the level of unemployment and the rate of … The offers that appear in this table are from partnerships from which Investopedia receives compensation. A steepening yield curve indicates that investors expect stronger economic growth and higher inflation, leading to higher interest rates. This should cause the yield curve to “flatten out” (see the illustration below). A strategy that is employed by many such participants is “the flattening trade”. The Phillips curve is named after economist A.W. The spread on both Treasuries is 200 basis points. The underlying concept of a flattening yield curve is straightforward. The flattening aspect can be easily expressed by buying a long-term bond, while simultaneously shorting a shorter-term bond. The New York Institute of Finance has a faculty of industry leaders and offers a range of program delivery options including self-study, online and classroom. Many traders think in terms of buying (selling) interest rate futures to capitalize on anticipated falling (rising) yields in response to changes in Fed policy or to dynamic macroeconomic conditions. This decrease in demand for the longer-term Treasury should cause its price to fall, causing its yield to increase; the greater the yield difference, the more profitable the curve steepener trade strategy becomes. Most importantly, the volatility (duration) of the 10-year note is not as volatile as the 30-year bond. Under this strategy, the trader or portfolio manager would short sell the 10-year treasury and simultaneously buy long the 30-year bond. For investors in the curve-steepener trade, the updraft in Treasury yields of the past 48 hours is more than just a welcome reprieve -- it also signals a long-awaited regime shift. Bond Trading Strategy: The Flattening Trade. In ETFs, this trade … In other words, the yields on long-term bonds are rising faster than yields on short-term bonds, or short-term bond yields are falling as long-term bond yields are rising. The curve steepener trade involves an investor buying short-term Treasuries and shorting longer-term Treasuries. Fixed Income Trading Strategy & Education. The graph is plotted with interest rates on the y-axis and the increasing time durations on the x-axis. The yield curve risk is the risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument. The yield curve is a graph showing the bond yields of various maturities ranging from 3-month T-bills to 30-year T-bonds. June 25, 2018, 12:37 PM EDT ... puts their forecast for the 2- to 10-year curve flattening … An article by the New York Institute of Finance Yield Curve Analysis instructor Bill Addiss. Also, what is a flattener? What is a flattener trade? Let’s take a look at the flattening trade over two different segments at the long end of the yield curve: the one between five and 30 years and the one between 10 and 30 years. For example, you may buy a 6m2y payer, while selling a duration-weighted 6m5y payer. Since short-term bonds typically have lower yields than longer-term bonds, the curve slopes upwards from the bottom left to the right. A positive butterfly is an unequal shift in a bond yield curve in which long- and short-term yields increase by a higher degree than medium-term yields. Flattening? An example of an instance where the yield curve appears steeper can be seen in a two-year note with a 1.5% yield and a 20-year bond with a 3.5% bond. In this course, you’ll develop a complete set of desk-ready skills for fixed income market participants. If after a month, both Treasury yields increase to 1.55% and 3.65%, respectively, the spread increases to 210 basis points.