Curve Steepener Trade

What Is a Curve Steepener Trade?

A curve steepener trade is a strategy that utilizes derivatives to benefit from escalating yield differences that happen as a result of increases in the yield curve between two Treasury bonds of different maturities. This strategy can be effective in certain macroeconomic scenarios in which the price of the longer-term Treasury is driven down.

Understanding Curve Steepener Trades

The yield curve is a graph showing the bond yields of different maturities going from 3-month T-bills to 30-year T-bonds. The graph is plotted with interest rates on the y-pivot and the rising time durations on the x-hub. Since short-term bonds typically have lower yields than longer-term bonds, the curve inclines upwards from the bottom left to the right. This is a normal or positive yield curve.

Sometimes, the yield curve might be inverted or negative, implying that short-term Treasury yields are higher than long-term yields. At the point when there is little or no difference between the short-term and long-term yields, a flat curve follows.

The difference between the short-term and long-term yield is known as the yield spread. Assuming the yield curve steepens, this means that the spread between long-and short-term interest rates increases. In other words, the yields on long-term bonds are rising faster than yields on short-term bonds, or short-term bond yields are falling as long-term bond yields are rising. At the point when the yield curve is steep, banks are able to borrow money at a lower interest rate and loan at a higher interest rate.

An illustration of an instance where the yield curve seems steeper should be visible in a two-year note with a 1.5% yield and a 20-year bond with a 3.5% bond. The spread on both Treasuries is 200 basis points. In the event that after a month, both Treasury yields increase to 1.55% and 3.65%, respectively, the spread increases to 210 basis points.

Special Considerations

A steepening yield curve indicates that investors expect stronger economic growth and higher inflation, leading to higher interest rates. Traders and investors can, therefore, take advantage of the steepening curve by entering into a strategy known as the curve steepener trade. The curve steepener trade includes an investor buying short-term Treasuries and shorting longer-term Treasuries. The strategy utilizes derivatives to hedge against an extending yield curve. For instance, an individual could utilize a curve steepener trade by utilizing derivatives to buy five-year Treasuries and short 10-year Treasuries.

One macroeconomic scenario in which utilizing a curve steepener trade could be beneficial would be in the event that the Fed chooses to significantly bring down the interest rate, which could debilitate the U.S. dollar and influence foreign central banks to stop buying the longer-term Treasury. This decline in demand for the longer-term Treasury ought to make its price fall, making its yield increase; the greater the yield difference, the more profitable the curve steepener trade strategy becomes.

Highlights

• A steepening yield curve indicates that investors expect stronger economic growth and higher inflation, leading to higher interest rates.
• Assuming the yield curve steepens, this means that the spread between long-and short-term interest rates increases — for example yields on long-term bonds are rising faster than yields on short-term bonds.
• A yield curve is a graph of the bond yield of different maturities.
• The curve steepener trade includes an investor buying short-term Treasuries and shorting longer-term Treasuries.
• Curve steepener trades benefit from rising yield differences as a result of an increase in the yield curve of two T-bonds of different maturities.