Fixed Income Update: Trading the Treasury Yield  Curve Fixed Income Update: Trading the Treasury Yield  Curve Fixed Income Update: Trading the Treasury Yield  Curve

Fixed Income Update: Trading the Treasury Yield Curve

Bonds 10 minutes to read
Redmond Wong

Chief China Strategist

Summary:  As the Treasury yield curve tends to steepen when the Fed hiking cycle ends, it is worthwhile to look at some actionable ways to benefit from the curve steepening. In this note, we explain how an investor may use the T-note futures to implement his view on the yield curve and how to come up with the approximate hedge ratio. This note is for inspiration only and readers are reminded that trading the yield curve using futures contracts is of high risk and is not suitable for investors who are not experienced in futures trading.

Recap of the case for a steepening yield curve

In our research note on March 24, we put forward the case for a steepening yield curve as the current interest rate hiking cycle is approaching its end. To recap, as shown in Figure 1, in the past six major interest rate cycles, when the Fed was about to pause hiking, the 2-10 year yield curve commenced its longer march steeper. In those episodes, short-term Treasury note yields came down more than the longer-end Treasury bond yields, and the yield curve turned more positively sloping, that is longer-end bond yields higher than short-term note yields. 

Figure 1. The 2-10-year yield spread and the upper bound of the overnight Fed Funds target; Source: Bloomberg, Saxo

How to trade the yield curve steepening

When the yield curve is steepening, investors can benefit by buying the short-term Treasury notes and selling short the longer-term Treasury bonds at the same time at a ratio that adjusts for the duration. There are many ways to implement this strategy and we will focus in this note on a cost-effective and relatively straightforward way to put the strategy at work as an illustration. What follows is only for inspiration purposes and does not constitute any trade or investment advice. It is important to note that futures trading is risky and is only for investors who are experienced and well-versed in the market dynamics and risk features of futures trading.

While investors can buy the 2-year Treasury notes and borrow the 10-year Treasury notes in the repo market to go short the latter, it is usually more convenient to use futures contracts to implement the strategy. To put to work a curve steepening idea, investors can buy the CME 2-Year T-note futures and at the same time sell the CME 10-Year T-note futures of the same contract month (H for March, M for June, U for September, or Z for December).

In the U.S. Treasuries market, the taxonomy is to call all Treasury securities with an original maturity from 2 years to 10 years “notes” and those with original maturities longer than 10 years “bonds”. For our discussion here, the two terms are used interchangeably as most readers may tend to use the term “bonds” regardless of their tenors.

The 2-year T-note futures contract has a notional value of USD200,000 and the bonds that are deliverable to settle the contract are Treasury notes with an original term to maturity of not more than five years and three months and a remaining term to maturity of not less than one year and nine months. The futures price tends to track the price of the cheapest-to-deliver bond among these deliverable bonds.

Figure 2. Banks are tightening lending standards Source: Bloomberg, Saxo

The 10-year T-note futures contract has a notional value of USD100,000 and the bonds that are deliverable must have a remaining term to maturity of at least six and a half years, but not more than 10 years. The price of the 10-year T-note futures tends to track the cheapest to deliver issue among these bonds. 

Figure 3. The 10-year T-note futures; Source: Saxo

Getting the ratio right between the long 2-year T-note futures and the short 10-year T-note futures

When yields go down, bond prices go up; when yields go up, bond prices go down. The sensitivity of bond prices to each basis point movement in yield, however, depends, among other things, on the tenor of the bond. The longer the tenor, the more sensitive the bond price to yield movements, other things being equal. As a result, for every one basis point movement, the price change in the 10-year note will be larger than the price change in the 2-year note.

It is important to remember this strategy is to benefit from a steepening of the yield curve but not to bet on the absolute level of yields. Therefore, we need to implement the strategy on a hedge ratio between the 2-year T-note futures and the 10-year T-note future to adjust for the differences in price sensitivity to yield changes. To do that, we want to go long the number of 2-year T-note futures contracts that will move by approximately the same dollar amount in absolute terms against the short in each 10-year T-note futures contract if yields move by the same amount and in the same direction for both tenors. In other words, there will be significant profit and loss only in the case that the magnitudes or directions of the changes in yields for the two contracts are different.

Instead of going through the mathematics to calculate the hedge ratio, a convenient way is to use the futures DV01 at the portal of the CME Group here and click on “2 Yr” under “Deliverables”. The value of futures DV01 means how much the value of one 2-year T-note will change per every basis point movement in yield. For example, In Figure 4, when the 2-year yield falls one basis point, the 2-year futures price will go up approximately by USD34.36. This value will vary as the yield level changes and if there is a shift in the cheapest to deliver bonds. However, for our purposes here, it is sufficient to use this value to calculate the hedge ratio.

Figure 4. DV01 of the 2-year futures contract; Source: CME Group

Likewise, investors can find the DV01 for the 10-year T-note futures at the same CME portal and click on “10 Yr under “Deliverables”. In this case, the DV01 is USD65.94. In other words, when the 10-year yield falls by one basis point, the 10-year T-note futures price will go up by USD65.94.

Figure 5. DV01 of the 10-year T-note futures; Source: Bloomberg, Saxo

Therefore, the hedge ratio between the 2-year T-note futures and the 10-year T-note futures will be approximately 1.9, which is USD65.94/USD34.36. To do a steepening trade for every 10 contracts short in the 10-year T-notes futures, investors need to go long 19 contracts in the 2-year futures.

Remember to roll the contracts

Both the 2-year and the 10-year T-note futures contracts are for physical delivery. The side that is short the contract has the option to notify the exchange to deliver a deliverable bond the next business day to the side that is long the contract starting on the last business day of the month preceding the contract month. For example, the first notice day for the June 2023 contracts is May 31, 2023. Therefore, it would be advisable for investors to roll their June contract before May 31. 

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