Bond Trading Strategy: The Flattening Trade
An article by the New York Institute of Finance Yield Curve Analysis instructor Bill Addiss.
With the announcement yesterday by the FOMC that they will continue with QE3, the question once again remains: how long will they continue with this intervention? With the Fed’s target of 2.5% for inflation and 6.5% for unemployment, it appears that this intervention will not end soon. However, active traders and participants in the bond market need to position themselves for “what’s next”. A strategy that is employed by many such participants is “the flattening trade”
For many active market participants, successful bond trading is not merely picking a point along the yield curve, and speculating whether interest rates will go up or down, but rather to speculate on the shape and slope of the yield curve. Specifically, under QE3, the Fed is actively buying treasuries with maturities of 2-10 years (to the tune of $85 billion of a month). This serves to lower those rates, given the increase in prices. Once they reduce or eliminate this intervention, we can assume that the yields on these maturities should rise, relative to longer maturities, such as the 30-year bond. This should cause the yield curve to “flatten out” (see the illustration below). One active trading strategy to take advantage of this scenario is to engage in what is referred to as a “flattening trade”. Under this strategy, the trader or portfolio manager would short sell the 10-year treasury and simultaneously buy long the 30-year bond. By doing so, you are now not speculating on changes in the absolute level of interest rates, but rather the yield differential between these two maturities. Specifically, positioning yourself for the yield differential to narrow.
When incorporating this strategy, there are some important considerations to keep in mind. Most importantly, the volatility (duration) of the 10-year note is not as volatile as the 30-year bond. To account for this, the trade must be “duration weighted” meaning the amount of bonds traded must be adjusted accordingly.
Additionally, whereas I used the cash treasury market to illustrate this potential opportunity, it can be utilized in other markets as well, specifically the futures market. There are T’note and T’bond futures contracts on the CME that allow the speculator to incorporate this same strategy in the futures market. One of the benefits of this is the utilization of margin to further enhance risk/reward opportunities. The futures exchanges themselves recognize the more conservative nature of this strategy relative to an outright purchase or sale of contracts. Accordingly, they offer reduced initial margin requirements for a spread trade, when compared to outright buying or selling of futures contracts.
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