Yield Curve explained

from: http://www.traderdaily.com/magazine/article/16853.html

Be it steep or inverted, traders enjoy a good yield-curve bet. But with the long bond taking on a life of its own and credit markets gone haywire, playing rate spreads can be one dangerous game.

Anyone who has ever attempted pairs trading can attest to the degree of difficulty involved in trying to call two simultaneous directional moves. Two securities, two chan­ces to be wrong.

Some might argue that a spread trade should, theoretically, be somewhat less risky than taking an outright position. Extracting tasty spread profit from two ends of the U.S. interest-rate yield curve is an old standby, and it can be done — if you know what you’re doing. But it’s hazardous prospecting. Nego­tiating the curve gets particularly difficult in turbulent trading environments — such as those seen in these credit crisis–plagued months, in which wrenches in the works (whether flung by the Fed or some rogue tra­der) are constantly undermining even the most reliable givens.

Granted, “buy the two, sell the 10” doesn’t sound especially intimidating, but let’s back up for a moment. As we all well know, a yield curve is nothing more than a plotted pattern playing out on an L-shaped graph: maturities along the horizontal, yields along the vertical. That spectrum of yields versus maturities, from 30-day bills to 30-year bonds, typically charts as a curve, with traditionally smaller yields corresponding to shorter durations and yields inching upward as the durations get longer. If I lend a friend 20 bucks for a half-hour, I don’t expect much in return except my 20 bucks; if he requires a month to pay it back, well, he had better be prepared at least to buy me a beer.

A yield curve exists for all interest-rate markets, including corporate and municipal bonds, inflation-linked bonds and interest-rate swaps. However, when someone speaks of the yield curve, he’s referring to the U.S. Treasury market.

Market strategists have used the yield curve as an economic barometer for decades. An inverted yield curve, in which short-term yields grow larger than long-term, often serves as a harbinger of recession. Then again, nothing about the yield curve is ever set in stone; it has, over time, bewildered the best of them. Still, “the yield curve is far and away the best indicator of trends in the economy,” says Peter Borish, a director at Pali Capital, a Manhattan-based financial-services firm.

The curve is an indicator of inflation, of stock prices and of the economy in general. As interest rates move, so do yield curves, which generally exhibit three common shapes: normal, flat or inverted. “The shape of the curve is more important than the absolute level of rates,” Borish points out.

Things can (and do) get kinky. It’s not unusual for the rates for three- and six-month Treasury bills to be higher than those for, say, two-year Treasury notes. Those two-year note yields can, at times, be higher than 10-year-note yields.

The Chicago Board of Trade’s two-, five- and 10-year Treasury futures are among the principal instruments for trading this serpentine phenomenon, with the “two-10” spread considered the most common play. The CBOT actually had a number of yield-curve spread futures approved by the CFTC in the mid-’90s, though they never garnered much attention and were soon delisted.

Six or so years ago, when the 30-year bond was still the long end, the note-over-bond, or “NOB,” spread was the happening trade. That has since drifted into obscurity given the 10-year note’s new prominence as the long-end benchmark and the sporadic issuance of 30-year bonds. The current flavor of the month is the “tens-under-twos,” or “TUT,” spread.

Yield-curve spread trades come in two main varieties: flattening and steepening. Banks have traditionally been the biggest ­players. “Big-money center banks have money coming in every day,” explains Gregory Cotter, president of Roslyn Heights, New York–based Tri Global FX and former chief FX dealer at Société Générale. “They’re always long in cash and always looking to lend, which makes them trade the curve to manage their risk.”

The spread trade is a hedge of sorts: buying one security while selling another, hoping to profit on a convergence or divergence. For many traders accustomed to outright directional bets, this is a foreign concept. “I’m not a good spread trader,” admits Borish, who prior to Pali Capital ran OneChicago. ­Going back further, he was director of ­research at Tudor Investment Corp. Tantal­izing as is it may be to take a tea-leaf reading and dive in, Borish knows that correctly calling the curve is easier said than done. “If I’m trading twos against tens, I want to win on both sides of the trade,” he says, “even though I know I can’t.”

One’s comfort level with the curve is often a byproduct of one’s trading background. “If you came in on the commodities side, like beans or cotton, you were probably trained as a spread trader,” Borish says. “The energy guys, the agriculture guys, were spread traders, along with the bond guys.”

The off-the-floor traders, especially those who were brought up in the heyday of the 1990s equities bull market, were more used to simple directional trading. Cotter, who trades currencies, keeps a close tab on the overall shape of the curve at all times. “I watch the steepness,” he explains. “If banks get a steep curve, they can make money all day long. If the curve is steep, eventually the economy will be all right.”

In reality, some argue, these relationships were never as strong as alleged. They began to collapse in the mid-’90s, when the Japanese experiment in near-zero interest rates led to the creation of an international yield curve anchored at the short end by Japanese short-term rates. Such a situation made everyone else’s effective yield curve positively sloped as part of the yen carry trade. This global trend contributed to the late-’90s and mid-2000s asset bubbles in stocks and real estate, respectively.

Most traders understand just how difficult it is to curve-trade. “More than a few well-known traders got hammered trading the curve last year,” Cotter points out. “I’m talking about some of the smartest guys out there. That they couldn’t get it right shows it’s just not easy to do.”