Trading the Inverted Yield Curve

Recent headlines are all about the yield curve being inverted and how low yields are now. Generally when there's such consensus and focusing on the extremes in the news, I like to see if there are any opportunities to be traded.

You can skip to the recommendated implementation in Part 2 or go to the bottom of this page for the implementation of the synthetic position

First, on the low rate environment

The problem is that it is not so simple as to go short on bonds (long yields) in hope that since it's at a historical low, it will rebound. The reason is because we are likely at the late stage of the business/economic cycle, and there's the looming risk that equity markets will undergo a correction of some degree soon. When that happens, it's almost certain that rates will be lowered even further to cushion the fall. Therefore it is not unlikely that rates go even lower from where they are right now.

Next,  on the inverted yield curve

This is a better play in terms of likelihood. The inversion of the yield curve is a relative play and we can implement a long-short strategy to benefit from the eventual steepening of the curve.  If a recession happens, this will take a little longer. If there's no recession and the economy chugs on, then the curve should become steeper sooner as confidence is regained.

Which spread to trade

While the focus is usually on the 2YR-10YR spreads, we can take a look at the other combinations to see which one is the most 'underpriced' now compared to its historical values.

This turns out to be the 1MO-10YR spread, but this is not readily implementable. Thus, we will look at implementing the benchmark 2YR-10YR spread.

10yr-spreads-hist

 

20yr-spreads-hist

 

30yr-spreads-hist

 

Implementation

There are ETFs that directly track this. Examples are the new STPU, and the older STPP (ETN). You can even try shorting the ETF FLAT. The problem with these are the illiquidity (spread costs) and the expense ratio.

A cheaper DIY way is  to use the bond ETFs for the short end and the long end: SHY and TLT. These 2 tickers respectively target the  1-3 years and the 20+ years portion of the curve. Going long on SHY and short TLT is akin to trading the yield spread, as we can see how they move in similar fashion, though not perfectly.  

You can also attempt the trade using futures /ZN and /ZT if you have access and margin.

Below are some details to consider for the SHY-TLT synthetic position. The rolling correlation uses the 60-day change in level (not percentage) and a 60-day rolling window.

SHY

TLT

Synthetic position (1x SHY - 1x TLT)

Note of caution - the SHY was not very responsive to the 2YR rates (and thus also the resulting price spread vs yield spread) pre-2009, but it seems to be ok now.

To execute this spread as a steepener, we will need to long SHY and short TLT, one unit each.