July 12, 2011
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The yield curve, as measured by the spreads between the yields of the 10-year note (i10) and the 2-year note (i2), has now steepened to levels seen only twice before since 1965. This is only the third time in the last 45 years (the time period considered in my study) that investors can take advantage of a flattening of the yield curve this extreme, an opportunity that should not be missed.
Figure 1 shows the historical values of (i10 – i2) and the function f = [1 – i2 /i10].
Both graphs are peaking now and the obvious future direction of the curves is downwards, which would flatten the yield curve.
The current value of f = 0.87 is all-time high and is an indication of the abnormally low value of i2. The theoretical maximum possible value of f is 1.0 which would require i2 to be zero percent. The ratio i2/i10 = 0.13 has never been as low as it is now.
The conditions for f to increase and the yield curve to steepen are:
- i10 increases at a faster rate than i2.
- i2 decreases at a faster rate than i10.
The conditions for f to decrease and the yield curve to flatten are:
- i10 decreases at a faster rate than i2.
- i2 increases at a faster rate than i10.
The unprecedented high value of f cannot last for very much longer and according to historical precedent should soon decline. Most likely, condition four will prevail to flatten the yield curve.
Trading the spread
The long-term average of (i10 - i2) is 0.7% and the 10-year moving average of (i10 - i2) is now at 1.5%. The current yield spread is approximately 2.6%. If the spread declines to its 10-year moving average then this would represent a decline of about 1.1%.
One could use Treasury futures contracts to profit from this decline. One would sell the short end of the curve by selling 2-year T-Note futures and buy the long end by buying 10-year T-Note futures, with the relative sizes of the trades adjusted to establish a neutral spread position.
A more convenient way is to buy the iPath US Treasury Flattener ETN FLAT. The ETN follows the Barclays Capital US Treasury 2Y/10Y Yield Curve Index and attempts to increase by $0.10 for every one basis-point (0.01%) decline in the yield spread. A 100 basis-point decline in the yield spread should equal a $10 return for FLAT. Thus for an anticipated yield decline of about 1.1%, FLAT would increase in value by approximately $11.00. With FLAT trading currently at about $48, this would represent a gain of about 23%.
The values of FLAT and STPP
The inception date of the ETNs FLAT and STPP was August 9, 2010. (STPP is the inverse of FLAT, and should increase by about $0.10 for every one basis-point increase in the yield spread). The principal amount for each ETN was $50 at the inception date.
One can calculate the hypothetical values of the ETNs which would apply to a date before inception by using the Barclays Capital US Treasury 2Y/10Y Yield Curve Index values, fees, rolling costs and interest gain applicable to the ETNs. I have done this for the period January 2006 to the inception date and the values are shown in figure 2.
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