The opinions expressed in this report are those of Inspirante Trading Solutions Pte Ltd (“ITS”) and are considered market commentary. They are not intended to act as investment recommendations. Full disclaimers are available at the end of this report.
Highlights
Introduction
U.S. Treasury securities are debt obligations issued by the Department of the Treasury to finance government spending. Backed by the full faith and credit of the U.S. government, they are considered among the safest investments available, reflecting the strong trust placed in the government's ability to meet its obligations. These securities come in various maturities and structures, designed to meet different investment needs:
- Treasury Bills (T-Bills) are short-term securities with maturities ranging from a few days to one year.
- Treasury Notes (T-Notes) are medium-term securities with maturities of 2, 5, or 10 years.
- Treasury Bonds (T-Bonds) are long-term securities with maturities of 20 to 30 years.
The U.S. Treasury market forms the cornerstone of the global financial system, offering a combination of safety, liquidity and benchmark status that few other instruments can match. While some investors may perceive treasuries as being primarily for institutional participants compared to equities, commodities or forex, a deeper understanding of these instruments becomes increasingly essential for investors in today's complex markets.
Treasuries are far more than just debt instruments. One of their most critical roles is serving as the default risk-free asset against which other investments are measured. This influence extends beyond U.S. borders, affecting borrowing costs, currency valuations and global capital flows. Treasury yields serve as reference rates for a wide range of financial products, impacting areas of everyday life such as mortgages, corporate bonds, credit cards and student loans.
Furthermore, the Federal Reserve (Fed) conducts open market operations with Treasuries to manage the money supply and influence short-term interest rates, thereby guiding the economy toward its dual mandates of maximum employment and price stability.
In times of economic uncertainty, Treasuries are often the asset of choice for investors seeking safety, as seen during the 2008 financial crisis and the COVID-19 pandemic. Their status as a safe haven, along with their inverse correlation to riskier assets, has also contributed to the widespread use of the 60-40 portfolio strategy, which typically allocates 60% to equities and 40% to treasuries for diversification and enhanced risk-adjusted returns.
In addition, Treasury yields serve as more than just indicators of government borrowing costs; they also reflect market expectations regarding future economic growth, inflation, and monetary policy. For instance, a rising yield on the 10-year Treasury note often signals expectations of stronger economic growth and higher inflation, prompting shifts in investors' strategies and asset allocations.
Figure 1: U.S. CPI YoY vs. U.S. 10-year Treasury Yield (Monthly)
Understanding Treasury futures
Unlike purchasing physical bonds, trading Treasury futures offers investors flexibility and leverage. These instruments enable a wide range of strategies, including hedging exposure to interest rate risks, speculating on interest rate movements, and managing yield curve shifts, all without transacting in the physical bond market. Treasury futures are among the most liquid financial instruments worldwide, and their standardized nature simplifies the trading process compared to cash bonds.
While the complexities of bond delivery mechanisms, cash bonds, conversion factors and cheapest-to-deliver (CTD) options are beyond the scope of this article, we will focus on trading Treasury futures and inter-commodity spreads. For readers interested in these advanced topics, CME Group provides detailed materials.
Why do bond prices and yields move in opposite directions?
The prices of bonds are largely determined by interest rates, the bond issuers’ credit quality, duration of the bonds and the supply/demand in the market. A fundamental principle of fixed-income markets is the inverse relationship between bond prices and yields. This concept can be explained simply: When interest rates rise, newly issued bonds offer higher coupon rates (i.e., higher interest payments to bondholders). As a result, existing bonds with lower coupon rates become less attractive, driving their prices down to align their yields with the new, higher-rate bonds. Conversely, when interest rates fall, bonds with higher coupon rates become more valuable, increasing their prices.
Bond yield refers to the income return (from coupon payments) relative to the price paid for the bond. For example, suppose an investor purchases a bond with a face value of $1,000 and an annual coupon payment of $50 (coupon rate: 5%). If he buys the bond at its face value, the bond yield is 5%. However, if he purchases the same bond at a discounted price of $900, the bond yield increases to approximately 5.56% because he is receiving the same $50 annual payment on a smaller investment. Conversely, if he pays a premium price of $1,100 for the bond, the bond yield decreases to about 4.55%. This illustrates how the bond's yield varies inversely with its price. A higher bond price results in a lower yield, and vice versa.
CME Group Treasury futures derive their value from the prices of the underlying Treasury securities. Investors who expect yields to rise may express their views by selling Treasury futures, given the anticipated decline in bond prices. Conversely, if yields are expected to fall, investors may buy Treasury futures to capitalize on the corresponding price increase. Figure 2 shows the long-term inverse relationship between the 10-year T-Note futures price and the U.S. 10-year yield.
Figure 2: 10-year T-Note futures vs. 10-year Yield (Monthly)
Understanding duration
Beyond the inverse relationship between bond prices and yields, it is also essential to understand how bonds with different maturities respond differently to interest rate changes. Duration measures a bond's sensitivity to interest rate fluctuations, estimating the percentage change in the bond's price for a 1% (100 basis points) change in rates.
A higher duration indicates greater price sensitivity. For example, longer-maturity bonds like the 30-year T-Bond have higher durations compared to shorter-term bonds like the 2-year T-Note. This is because the formers’ cash flows are further in the future, making their present value more affected by changes in interest rates. The longer the time horizon, the more volatile the bond prices become, as amplified by more potential rate changes through the course.
It's important not to confuse duration with maturity. While maturity refers to the time remaining until the bond's principal is repaid, duration measures how sensitive the bond's price is to changes in interest rates, taking into account all coupon payments and the time value of money. Two bonds can have the same maturity but different durations if they have different coupon rates or payment structures. Duration provides a more comprehensive measure of interest rate risk than maturity alone.
Treasury inter-commodity spreads (ICS)
The yield curve
Having established the importance of bond maturities in pricing, we turn to an essential concept – the yield curve, which plots the interest rates of bonds with equal credit quality but differing maturities, typically U.S. Treasuries. The yield curve illustrates the relationship between short-term and long-term interest rates, providing insight into market expectations for economic growth, inflation and monetary policy.
Figure 3: U.S. Treasury yield curve
Under normal economic conditions, the yield curve slopes upward, indicating higher yields for longer-term bonds. This reflects the risks associated with time, such as inflation and uncertainty about future conditions. Investors demand higher yields to compensate for these risks. However, the curve can flatten when short- and long-term yields converge or invert when short-term yields exceed long-term yields – often a reliable predictor of economic recessions. The cases in early 2000s, 2007, 2020 and 2023 are prominent historical examples.
Figure 4: U.S. 2y10y yield spread
Implications of the yield curve's shape
The shape of the yield curve is more than an abstract economic concept; it has significant, tangible effects across various sectors of the economy and plays a critical role in shaping decisions made by policymakers, financial institutions, businesses and consumers.
Figure 5: U.S. Treasury yield curve's shape change over time
For central banks, the yield curve serves as a barometer of future economic activity. It influences decisions regarding interest rates, as well as quantitative easing or tightening measures. Adjustments to short-term interest rates primarily affect the short end of the curve, while expectations around future monetary policy impact long-term rates. The yield curve also affects the cost of government debt issuance. A steeper curve, for instance, raises the cost of long-term borrowing, which can have implications for a nation's budget deficit and fiscal planning.
In the financial sector, the shape of the yield curve has a direct impact on profitability. Banks, for example, typically profit from the spread between short-term borrowing costs and long-term lending rates. A steep yield curve enhances bank profitability as they can borrow at lower short-term rates while lending at higher long-term rates. In contrast, a flat or inverted yield curve narrows these margins, putting pressure on banks' earnings. Moreover, lending decisions are often guided by the yield curve. A steeper curve encourages more lending, stimulating economic growth, while a flatter or inverted curve leads to tighter lending standards, potentially slowing down economic activity.
Other financial institutions, such as insurance companies and pension funds, must manage their asset-liability portfolios carefully. These institutions often have long-term obligations that must be matched with long-term assets. A steep yield curve benefits them by allowing investments in higher-yielding long-term securities, which in turn improves their ability to meet future obligations.
The yield curve affects financing costs for businesses, particularly those reliant on loans for expansion and operational needs. This includes both long-term borrowing and short-term credit facilities. Additionally, the curve influences the cost-benefit analysis of new investments and capital expenditures. In some cases, businesses use the yield curve to forecast economic conditions, adjusting their strategies for inventory management, hiring and growth accordingly.
Lastly, consumers feel the impact of the yield curve through borrowing costs and saving rates. For instance, mortgage rates are closely tied to long-term yields, while short-term rates affect loans for cars, credit cards, and other personal borrowing.
Tools for yield curve trading
With a solid understanding of the yield curve and its broad economic significance, we now turn to the practical tools that allow investors and traders to capitalize on yield curve movements: Treasury inter-commodity spreads (ICS), offered by CME Group.
Treasury ICS are standardized futures spread contracts that facilitate the simultaneous buying and selling of Treasury futures with different maturities. This approach allows for the execution of both legs of the spread in a single transaction, reducing execution risk and slippage compared to executing individual legs separately. Additionally, margin offsets between the legs lower the margin requirements compared to holding outright positions in each futures contract. Most importantly for yield curve traders, these spreads are standardized with predefined ratios, making them easier to trade.
Determining ratios for Treasury ICS
Closely related to the concept of duration, a key term in understanding Treasury futures is the dollar value of one basis point (DV01). DV01 measures the change in the dollar value of a treasury, either cash or futures, for a 1 basis point change in yield. This metric is crucial for balancing the spread as the position is primarily influenced by changes in the yield curve, rather than a parallel shift in interest rates.
For example, suppose the DV01 of the 2-Year T-Note futures is $30 per contract, while the DV01 of the 10-year T-Note futures is $60 per contract. To construct a 2y10y spread, the ratio would be $60 / $30 = 2:1. An investor would trade two lots of 2-Year T-Note futures contract for one lot of 10-Year T-Note futures contract to ensure that the position is balanced in terms of interest rate risk.
Moreover, the price ratios equal the front leg quantity divided by the back leg quantity. For most Treasury ICS, the ratios are based on DV01, except for 2-Year Treasury futures ICS, where the price ratio is doubled to account for the $200,000 notional size.
The DV01 values for all available Treasury futures contracts, along with the predefined price and quantity ratios for various Treasury ICS, are regularly published through the Treasury ICS Analytics tool provided by CME Group.
Figure 6: CME Group Treasury inter-commodity spreads (ICS)
Pricing of Treasury ICS
The pricing convention is "net change on the day":
We can use the following table to illustrate the pricing of a 2y10y Treasury ICS (TUTZ4).
|
Contract |
Last Settle |
Current Price |
Net Change |
|---|---|---|---|
|
ZTZ4 |
103’080 |
103’060 |
103’060 - 103’080 = -0’020 |
|
ZNZ4 |
111’110 |
111’020 |
111’020 – 111’110 = -0’090 |
Rounded to the nearest tick, the TUT price is, therefore, 0'003.
Case studies
With a solid understanding of Treasury inter-commodity spreads (ICS) and the current macroeconomic environment, characterized by sub-trend economic growth, moderating inflation, ongoing rate cuts by the Fed, and uncertainties stemming from upcoming U.S. presidential elections and geopolitical conflicts, we can explore several trading strategies. These case studies illustrate how traders might utilize Treasury ICS to express their views on the yield curve and broader macroeconomic conditions.
Case study 1: Bull steepener in 2y10y spread (long TUTZ4)
The Fed has already initiated rate cuts in the current economic cycle, aimed at supporting growth amid declining inflation and rising unemployment. According to CME Group FedWatch Tool, short-term interest rates are expected to decrease more significantly in the near term.
Regardless of the outcome of the 2024 U.S. presidential election, both candidates will likely pursue fiscal policies involving increased government spending. Whether through social programs (under Harris) or infrastructure and defence spending (under Trump), this could lead to higher long-term yields as the government's borrowing needs increase.
Additionally, geopolitical tensions in Ukraine and the Middle East are likely to drive up commodity prices, especially energy, which could rekindle inflation expectations and keep long-term yields elevated.
Given these factors, it is reasonable to expect a bull steepening of the yield curve – defined as short-term yields falling more than long-term yields, thereby steepening the curve.
In this scenario, a potential strategy would be to buy the 2-Year vs. 10-Year Treasury ICS (TUTZ4). This involves purchasing two 2-Year T-Note futures contracts (ZTZ4) and selling one 10-Year T-Note futures contract (ZNZ4), maintaining a 2:1 ratio to balance the DV01 of the two legs. If the yield curve moves in a parallel shift without changing its shape or steepness, the profit and loss on the spread position would be negligible.
This strategy will profit if the 2-year yield declines more than the 10-year yield, or if the 10-year yield increases more than the 2-year yield. However, losses could occur if the 2-year yield falls less than the 10-year yield or if the 10-year yield rises less than the 2-year yield.
Risks to this strategy may arise if the Fed turns unexpectedly hawkish, delaying or pausing further rate cuts. This could lead to higher short-term yields as the market reprices its expectations, while long-term yields could decline if market participants believe the hawkish stance will suppress economic growth.
Figure 7: U.S. 2y10y Treasury Yield spread (Weekly)
Assume that the steepener position was established as the following:
- Long two lots of 2-Year T-Note futures with implied yield = 4.06%, and DV01 = $33
- Short one lot of 10-Year T-Note futures with implied yield = 4.07%, and DV01 = $63
- Implied 2y10y yield spread is 4.07% - 4.06% = 0.01%
The following table shows the different hypothetical scenarios for the steepener position.
|
Scenarios |
2y implied yield |
10y implied yield |
2y10y yield spread |
Profit and Loss |
|---|---|---|---|---|
|
#1 Bear steepening |
4.06% |
4.08% |
0.02% |
(4.08% - 4.07%) x 100 x 63 = $63 |
|
#2 Bull steepening |
4.05% |
4.07% |
0.02% |
(4.06% - 4.05%) x 100 x 33 x 2 = $66 |
|
#3 Bear flattening |
4.07% |
4.07% |
0% |
(4.06% - 4.07%) x 100 x 33 x 2 = -$66 |
|
#4 Bull flattening |
4.05% |
4.05% |
0% |
(4.06% - 4.05%) x 100 x 33 x 2 + (4.05% - 4.07%) x 100 x 63 = -$60 |
Case Study 2: Bull flattener in 5y30y spread (short FOBZ4)
Although the market has priced in additional rate cuts, the Fed has emphasized a data-dependent approach to monetary policy. Recent economic data suggests the U.S. economy may not require aggressive rate cuts, which could result in more stable short-term yields.
Meanwhile, long-term yields have reached levels not seen in decades, offering attractive opportunities for institutions with long-term asset-liability management needs, such as insurance companies and pension funds. These institutions may lock in these high yields, driving demand for long-term bonds, which in turn pushes their prices up and yields down. Additionally, geopolitical uncertainties could further bolster demand for safe-haven assets like long-term Treasuries, decreasing long-term yields.
These factors suggest a potential bull flattening of the yield curve, where long-term yields fall more than short-term yields, flattening the curve.
A strategy for this scenario would be to sell a 5-Year vs. 30-Year Treasury ICS (FOBZ4). This involves selling three 5-Year T-Note futures contracts (ZFZ4) and buying one 30-Year T-Bond futures contract (ZBZ4) in a 3:1 ratio to balance the DV01 of both legs. Similar to the previous case, if the yield curve experiences only parallel shifts, the impact on profit and loss would be negligible.
This position will generate profit if the 5-year yield falls less than the 30-year yield, or if the 30-year yield rises less than the 5-year yield. Losses would occur if the 5-year yield falls more than the 30-year yield, or if the 30-year yield rises more than the 5-year yield.
Potential risks to this strategy include a more dovish Fed than expected, an uptick in inflation, or a reduction in geopolitical tensions, all of which could reduce demand for long-term Treasuries and result in a steeper yield curve between the 5-year and 30-year maturities.
Figure 8: U.S. 5y30y Treasury Yield Spread (Weekly)
CME Group offers a wide variety of spread combinations for trading the Treasury ICS. The top five by trading volume are: ZT vs. ZF (TUF), ZF vs. ZN (FYT), ZN vs. TN (TEX), ZN vs. ZB (NOB), and TN vs. ZB (NCB).
Conclusion
Throughout this article, we have covered the foundational concepts of Treasury instruments, explored the dynamics of the yield curve, and examined how traders can leverage market expectations through case studies involving Treasury ICS strategies.
Looking ahead, there are numerous opportunities for further exploration. For instance, future-cash trading strategies offer a compelling way to engage with the Treasury market through basis trades. They take advantage of price differentials between futures contracts and their underlying cash bonds. Many institutional investors and professional traders actively participate in this space.
Moreover, considering the international context of government bonds opens up a wide range of trading possibilities. Government securities from major economies like the U.S., European Union and Japan are often viewed as fungible due to their high credit quality and liquidity. The movements of these bonds tend to be correlated, reflecting global macroeconomic trends and synchronized monetary policies. By understanding the fungibility of government bonds, traders can engage in cross-market strategies, such as yield curve arbitrage between different countries or currency zones. This global perspective enables diversification and allows traders to capitalize on relative value opportunities across international bond markets.
Additionally, integrating foreign exchange considerations into bond trading strategies can further enhance potential returns or provide hedging against currency risk. Since government bonds are denominated in local currencies, fluctuations in exchange rates can significantly impact the overall performance of international bond investments, allowing traders to better navigate the risks and opportunities associated with global bond markets.
Figure 9: Government 10-year Yields of Major Economies (Weekly)
The information and opinions expressed in this market commentary belong to Inspirante Trading Solutions Pte Ltd. They are intended for information purpose only and do not constitute investment recommendation or advice. Please refer to full disclaimers at the end of the commentary.
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