As a 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 NOB
spread 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 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
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