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As the recent article in Bespoke pointed out, “It has been three weeks now since the Fed formally announced its $400 billion Operation Twist program on September 12th. If early indications are a sign of what's to come, however, this will be the third straight time the Fed has tried and failed to lower long-term interest rates through the Treasury market. “
Operation Twist involves selling short-term Treasuries in exchange for the same amount of longer term bonds. The policy’s intent is lower yields on long term bonds, while keeping short term rates little changed, in essence, to flatten the yield curve. A failed policy in 1961, I seriously doubt that Bernanke himself, thought that increasing the average maturity or “twisting” the Fed’s portfolio, would have any effect on the economy or rates. In reality, it was more of a PR move designed to reiterate the central bank’s policy objectives, and maintain credibility with the investing public.
While the Fed’s policy attempts have fallen short at bringing down rates and invigorating the economy, there is no denying the impact they have had on the broader market. Once again, the SPX appears to have put in a swing bottom that is highly correlated with the Fed’s actions, and once again rates are rising concomitantly. (Chart 1)
Whether intended or not, the Fed’s machinations have an effect on the markets, that can present observant traders with relevant opportunities that have a high probability of success. Operation Twist, of course, involves the simultaneous sale and purchase of both short and long-term securities, so it’s impact will be the greatest on the Treasuries’ yield curve.
Investopedia defines the yield curve as, A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
In futures terms , it is the spread between the yields of the same security with differing maturities, and the NOBspread is one of the most heavily traded yield curve spreads. If you expect the yield curve to to steepen, you typically want to buy the spread. If you expect the yield curve to flatten, you will want to sell the spread.
If a trader expects the yield curve to steepen, he can buy the 10 year note and sell the 30 year bond( buy the NOB). When the yield curve steepens, the 10 year Treasury cash yield will fall relative to the 30-year Treasury cash yield, and the10-Year Note futures price will rise relative to the 30-Year bond’s futures price.That is, a long position in the 10-Year Note futures will gain more than a short position in 30-Year bond futures will lose. Due to the inverse nature between price and yield in Treasuries, the yield spread will increase, but the price spread will decrease as with any bull spread.The converse is true, for a trader that is expecting the curve to flatten.
True yield curve spread filters out directional effects (i.e., changes due to parallel shifts in the yield curve) and responds only to changes in the slope of the yield curve (i.e., non-parallel shifts).The goal is to filter out directional effects and design a spread trade that will respond only to changes in the shape of the yield curve. In order to do so, NOBS are usually traded as ratio spreads, with the current ratio being 5:2, notes over bonds. This ratio matches the dollar value of a 1-bp change (DV01) in the yield of the shorter-term maturity futures position and that of the longer-term maturity futures position. A DV01 indicates approximately what one futures contract will gain or lose in dollars for every 1-bp change in yield.
It is best to trade the NOB in the direction of the prevailing trend, by buying weakness at or near support or selling strength at or near resistance, however a mean reversion strategy can be utilized in a range market. A daily chart can be used to identify the prevailing trend, and a 15 minute chart is good for execution. Since the end of July/ beginning of August, the yield curve had been flattening, so selling the NOB on rallies, was the best strategy. However, in an ironic twist of fate, yields on treasuries have rallied, and so has the yield curve, since Operation Twist was implemented on Sept. 21. Until a bottom in yield and a change in the curve is confirmed, I would consider the curve trade a trading affair. (Chart 3)
Unfortunately, if you use NinjaTrader, their platform is not conducive to spread trading, so if you want to put on a spread, you have to leg it. You will also be unable to place a stop using the spread price, so it must be done dynamically. Other platforms, i.e., TT and Cunningham, cater more to spread traders. I like the “pairs suite” indicator, along with a few others that can be found on nexusfi.com (formerly BMT) or NT, that work just as well. In addition, I overlay the PRC2 indicator on the “pairs ratio” indicator, which provides me with support/resistance and a visual of the near -term trend, and use the RSI of the spread for confirmation. I trade the spread with a 2:1 ratio, instead of the recommended 5:2, just for simplicity’s sake, but one can experiment with different ratios to achieve different deltas.
“A yield curve spread trade is a speculative trade, but it shifts the burdenof speculation from taking a position on interest rate or price direction to taking a position on what you expect the yield curve to do. This gives you an extra way to be right, for you have no concern for rate or price direction, only for yield curve steepening or flattening.”CME Group
Trading the NOB as a vehicle to trade the Treasury's yield curve may be an end game in of itself. However, the yield curve may aslo offer clues as to the direction of the equities markets. As is often the case, a change in the yield curve will occur, before a change in the market's direction, qualifying it as leading indicator.
Correlation between the two markets may go as high as 60% positively correlated to as low as 60% negatively correlated, depending on traders' perception of the market. In an environment when interest rates are falling, and Bond prices are rising, the market might view lower rates, as being good for the economy, and respond with higher stock prices.The converse is true for rising rates, and falling bond prices. In these cases, correlation between the two markets is positive as they are moving in sync.
Equities and debt are also alternative investment vehicles. If the stock market is strong, it might encourage capital to flow from bonds into equities. Alternatively, If the market is in a bear trend, there might be a "flight -to-quality, to the perceived safety of treasuries. In these cases the two markets are negatively correlated as they are moving in opposite directions.
In a normal yield curve, short-term rates are lower than long term rates. It is assumed that the Fed attempts to keep the short end down to spur economic activity, and that bond investors demand higher rates further out the curve to compensate for inflation. It is also assumed that the Fed and short end of the curve is the determinant of the slope of the curve. In general, bond traders link the dynamics of the yield curve to their expectations of the future economy. When the yield curve flattens it is usually accompanied by deflation or steady and low inflation and a slowing of the economy, and a steeping of the yield curve is usually the result of an accelerating economy and inflationary expectations.
If the market is breaking, and the yield curve is beginning to strengthen this may be a bullish divergence, and precursor to a reversal in the market. If the market is rallying, and the yield curve begins to flatten, this might be foreshadowing a top in the market.
In this case there is no divergence. The yield curve has flattened over the last three months, as bond yields have declined faster than the yields for notes. The NOB spread has led the equities markets by a few days. However, it was not necessary to follow the NOB spread, as the breakout occured on bonds simultaneously.
This confirms that bonds and equities are negatively correlated, once the FED has exhausted its set of tools to further boost the ailing economy.
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Would it be a good time to sell the TUF spread? I mean sell 5-year and buy the 2-year. I am assuming the 5-year yield would need to catch up to the 2 year, right?
Any advice is more than welcome.
Considering how close the Notes yields are to the Fed Funds rate ~2.5%, I believe treasury notes may be overpriced...
The bill is paying as much as the 5 year... crazy bonds...
