The yield curve has to un-invert eventually… right? (Part 2)

6 февр. 2023 г.

This week, we thought it will be interesting to review the trade from last week given the reaction post-FOMC, as well as discuss an alternative way to set up this trade.

Firstly, let’s review the post-FOMC/employment data reaction.



- Nonfarm Payrolls surprised to the upside, as over half a million jobs were added way above the estimates of a sub 200K number.
- Unemployment rate continues to fall further, reaching a 53-year low of 3.4%



A clear re-pricing has occurred since last Friday’s better-than-expected jobs data and Wednesday’s Federal Reserve meeting. With markets now expecting 1 more rate hike in May, bringing the peak rate up from the 475 -500 bps range to the 500-525 bps range.

Keeping this in mind, we go back to our analysis last week to understand this situation and historical precedence.



While the time for a pause in rate hike seems to be pushed back, in the grand scheme of things, we think that this has only kept the window of opportunity for this trade open for longer and at a more attractive entry point now.

Without repeating ourselves too much, we encourage readers to take a look at our idea last week which explores the historical correlation between the peaking of yield curve inversion and the pause in Fed rate hikes.

Link to our last week’s idea:

This week, let’s tap into a different instrument. Here, we aim to take a short position on the 2Y-10Y yield differential by creating a portfolio of Treasury futures to express this view.

To do so, we would have to first select the 2 instruments, the 2-Yr Treasury futures is a straightforward choice for the short end. But for the 10-Yr leg, we have a choice of the '10-Yr Treasury Note Futures' vs the 'Ultra 10-Yr Treasury Note Futures'. Digging into the contract specification, the 'Ultra 10-Yr Treasury Note Futures' provide a better proxy for the true 10-year duration exposure as the delivery requirements are for Treasuries with maturities between 9year 5 months and 10 years. In comparison, the underlying of '10-Yr Treasury Note Futures' has a maturity between 6 year 6 months and 10 years.

With contract selection out of the way, the next step is to calculate the Dollar Neutral spread. This requires us to identify the DV01 of the front and back legs of the spread and try to match them. This is to ensure that the entire position remains as close to dollar neutral as possible, so we can get a 'purer' exposure to the yield difference between the front and back legs, and parallel moves are negated. CME publishes articles on this topic to explain the setting up of a DV01 spread clearer than we can explain. You can find them attached in the reference section below.

You can handily find the DV01 of the Cheapest To Deliver (CTD) securities on CME’s website.



In this case, we are looking at the 2Yr and Ultra 10Yr Treasury Futures to set up the trade. With the DV01 of the 2Yr at 34.04 and the DV01 of the Ultra 10Yr at 96.26.

The spread ratio can be calculated as 96.26/34.04 = 2.83. Rounding this to the nearest whole number, we would need 3 lots of2-Yr Treasury Future and 1 lot of Ultra 10-Yr Treasury Future, to keep the DV01 equal (neutral) for both legs of this portfolio.



Given our view of the 2Yr-10Yr yield spread turning lower, we want to short the yield spread. Yield and prices move inversely, hence, to short the yield spread, we long the Treasury Futures spread as it is quoted in price. We can long 3 ZTH3 Futures (2Y Treasury Future) and short 1 TNH3 futures (Ultra 10Y Treasury Future) to complete 1 set of the spread. However, since the 2-Yr Treasury Futures has a notional value of 200,000 while the Ultra 10Y Treasury Futures a notional of $100,000, the price ratio will be 6:1 when the position/leg ratio in the spread trade is 3:1. As such the current level would provide us with an entry point of roughly 494 with a minimal move in Ultra 10yrs representing 15.625 USD and that in 2Y representing 7.8125 USD.

While slightly more complex in setting up, this trade allows us another alternative to express the same view on the yield curve spread differential. Being able to execute the trade via different instruments allows you to pick the most liquid markets to trade or take advantage of mispricing in the markets.

The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/gopro/

Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.

Reference
cmegroup.com/education/courses/understanding-futures-spreads/trading-the-treasury-yield-curve.html
cmegroup.com/tools-information/quikstrike/treasury-analytics.html
cmegroup.com/education/articles-and-reports/introducing-micro-treasury-yield-futures.html
cmegroup.com/trading/interest-rates/files/TreasurySwap_SpreadOverview.pdf