How to Trade the Interest Rate Yield Curve
Newsletter #56
In this article we’ll talk about how to trade the dynamics of the interest rate yield curve.
Slope Trades
Steepeners
If a trader expects the yield curve to steepen, they can implement a steepener trade by buying a short-maturity bond and selling a long-maturity bond.
Buying a short-maturity bond reflects the expectation that short-term yields will decrease, while selling a long-maturity bond reflects the belief that long-term yields will rise. As a result, the yield curve steepens.
To construct the trade, the notionals of the bonds are chosen so that they have equal duration, making the trade duration-neutral. This ensures that the trader is exposed only to changes in the yield curve's slope and not to parallel shifts in interest rates.
Common curve points to trade include: 2s5s, 2s10s, 2s30s, 5s30s, 10s30s.
Flatteners
If a trader expects the yield curve to flatten, they can implement a flattener trade by selling a short-maturity bond and buying a long-maturity bond.
Selling a short-maturity bond reflects the expectation that short-term yields will rise, while buying a long-maturity bond reflects the belief that long-term yields will fall. As a result, the yield curve flattens.
The notionals are also selected so that the trade is duration neutral.
Curvature Trades
In addition to trading the slope of the yield curve, traders can also trade the curvature of the yield curve.
Long Butterfly (also called Fly for short)
If a trader thinks that the 5y yield is too high relative to the 2y and 10y yield, i.e. they think the curvative of the yield curve is too concave (rather than convex), they can put on a fly trade where they sell 50k duration of the 2y bond, buy 100k duration of the 5y bond and sell 50k duration of the 10y bond .
Unlike steepener or flattener trades, which bet on the slope of the yield curve (difference between short- and long-term rates), a fly trade bets on the relative movement of the belly (5-year) versus the wings (2-year and 10-year).
Common points to trade include: 2s5s10s, 5s10s30s, 2s10s30s
Short Butterfly
If the opposite is true and the trader thinks the 5y yield is too low relative to the 2y and 10y yield, i.e. they think the curvature of the yield curve is too convex, they can put of a fly trade where they buy 50k duration of the 2y bond, sell 100k duration of the 5y bond and buy 50k duration of the 10y bond.
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