The US treasury curve has garnered significant attention, especially on the ‘curve inversion’ where the short-end of the curve yields is higher than the long(er) end. What has the market worried is that it has been a very accurate predictor of future recessions.
Whether this is a case of causation or prediction is something that is still being debated, but nonetheless this has the attention of the Federal Reserve and some members have even stated that the possibility of ‘curve inversion’ is something they will consider when voting for Fed funds rate increases.
With this in mind, we propose a simple analysis on possible hedging strategies that tries to benefit from the future movements in the yield curve.
We have extracted (from the Treasury database) the past 4 years of Treasury yield rates. We then extract the daily moves of the yields, as well as the corresponding curve spread moves. In particular, we extract the 2y10y, 5y10y, 5y30y and 10y30y.
We then generate a correlation matrix between the par yield rates and the curve spreads (in terms of movements).
We predict, prior-hand, that the correlation between the short-end (such as 2y and 3y) should have a very high correlation to the curve spreads. This is the traditional thinking that, as the front-end of the curve moves, it tends to flatten or steepen the curve.
We find (instead), that the pair with the highest correlation is the 30y yield versus the 2y10y curve spread. By performing a pure quantitative/objective view-point, we hence extract the data for this pair for our trade analysis.
We perform a simple curve-fit (2-degree polynomial) to the data of x-axis = 30y, versus the y-axis = 2y10y spread movements. We find, happily, a curve with a positive convexity and almost zero gradient at the y-axis intercept (i.e. the curve slopes upwards overall on both sides).
The convex curve tells us, that on the basis of overall probability, if we enter into a short 30y yield trade, we can hedge it by entering into a long 2y10y curve steepener trade of a certain ratio (to the 30y yield).
The convexity of the curve tells us that whether the 30y yield increases or decreases, the 2y10y curve steepener should increase. And the increase of the 2y10y (when entered into the correct ratio to the 30y yield) will generate positive profits whether the 30y increases or decreases.