The shape of the yield curve is often considered to be a leading indicator of economic activity. When a recession is not expected, near-term yields tend to be lower than rates further out, since investors demand a term premium to compensate them for future uncertainty over yields.
Since July 2022, the yield curve has been inverted – near-term yields are higher than those further out in years – indicating concerns over the economy following the Federal Reserve’s biggest monetary tightening cycle since the 1980s in a bid to curb soaring inflation. The inversion is measured by the spread between the 2-year and 10-year Treasury yields. The "steepness" of the yield curve carries significant implications for investors and can have a deep influence on investor behavior.
The steepness of the yield curve is a reflection of market expectations regarding economic growth, interest rate movements and inflation. An upward-sloping yield curve, characterized by higher long-term yields than short-term yields, is typical and indicates an absence of concerns over a recession and rate cuts by the Federal Reserve. Conversely, a flattening or inverted yield curve, where short-term rates exceed long-term rates, signals potential economic slowdown or a recession, potential rate cuts or subdued inflationary trends.
Investors monitor the spread's movements to assess risk profiles, evaluate investment opportunities and rebalance portfolios accordingly. A steepening yield curve often prompts a shift towards riskier assets, such as equities, reflective of optimism regarding economic prospects. Conversely, a narrowing or negative spread may signal economic downturns or recessionary pressures, suggesting expectations of lower long-term interest rates compared to short-term rates. This may prompt a flight to safety, as investors seek refuge in bonds amidst economic uncertainties.
Exhibit 1: 2-10 On-the-run (OTR) spread (Jan 2020 to April 2024)
Exhibit 1 shows the 2-10 yield spread over since January 2020. The curve has been inverted since the middle of 2022.
Yield futures
| Contract | Symbol |
|---|---|
| 2-Year Yield futures | 2YY |
| 5-Year Yield futures | 5YY |
| 10-Year Yield futures | 10Y |
| 30-Year Yield futures | 30Y |
CME Group Yield futures are cash-settled instruments, with the final settlement value referencing the OTR 2-, 5-, 10- and 30-year Treasury securities, as tracked by the BrokerTec U.S. Treasury Benchmark Indices.
Yield futures were strategically designed to maintain a constant risk exposure. The design of the contract effectively eliminates convexity, the nonlinear relationship between price and yield, as it features a fixed $10 DV01 (dollar value per basis point of yield move).
The uniform DV01 across the entire curve facilitates straightforward inter-commodity spread (ICS) calculations and hedging. It allows for the hedging of any pair of points on the curve by employing a 1:1 ratio with the two Yield futures in the opposite direction. The 2Y-10Y Yield futures spread can be calculated by subtracting the price of the 2-Year Yield futures from the 10-Year Yield futures.
Exhibit 2: Yield futures curve (April 11, 2024)
As can be seen in Exhibit 2 above, the Treasury futures yield curve is inverted, with yields on the lower end of the curve exceeding yields on the higher end.
To learn more about Yield futures basics, visit Understanding Yield futures.
OTR spreads
The OTR yield curve spread refers to the difference in yields between the most recently issued Treasury securities in two different maturities. OTR securities are considered the most actively traded and liquid treasury securities, and the Treasury Department regularly auctions new securities, replacing older ones as the benchmark for pricing in the market. To calculate the OTR 2-10 spread, subtract the yield for the OTR 2-year Treasury from the yield of the OTR 10-year Treasury.
Trading the curve
Consider a scenario where a trader envisions a steepening yield curve. In such circumstances, the trader might opt to establish a spread position, taking a short position on the shorter end of the curve and a long position on the longer end.
On March 13, 2024, the OTR 10-Year Treasury had a yield of 4.191 and the OTR 2-Year Treasury had a yield of 4.618, resulting in a -0.427 spread.
Since the trader believes that the curve will flatten out, or steepen, he enters in the following position using Yield futures:
Short position of ten 2YY contracts @ 4.557
Long position of ten 10Y contracts @ 4.188
This position results in a futures spread position of -0.369, about 0.058 away from the OTR spread.
Success in this strategy hinges on the narrowing of the yields between the two maturities, resulting in an increase of the spread. Since the curve is currently inverted, this means that the trader believes that the spread will move in a positive direction.
On April 3, 2024, the position has evolved to the following:
Short position of ten 2YY contracts @ 4.620
Long position of ten 10Y contracts @ 4.350
The value of the spread is now -0.270, confirming that trader’s hypothesis. The value of the curve has steepened slightly and now is less inverted. The OTR spread has also steepened, with a value of -0.324.
The futures spread has narrowed by 9.9 basis points. Since yield futures have a DV01 value of $10, the value of the position has increased by $990 (9.9 basis points x $10 DV01 x 10 contracts).
The cash spread over the same window has narrowed by 10.3 basis points. With a $10,000 investment, the value of the spread would have increased by $1030.
Exhibit 3: 2Y-10Y spreads (January 2, 2024 to January 20, 2024)
| Cash | January 2, 2024 | January 20, 2024 |
|---|---|---|
| OTR 2 Year | 4.618 | 4.678 |
| OTR 10 Year | 4.191 | 4.354 |
| Spread Value | -0.427 | -0.324 |
| Futures | January 2, 2024 | January 20, 2024 |
|---|---|---|
| 2YY | 4.557 | 4.620 |
| 10Y | 4.188 | 4.350 |
| Spread Value | -0.369 | -0.270 |
Yield curve spreading is not only a mechanism for potential profit, it also serves as a risk management tool. Market participants have the opportunity to hedge against fluctuations in interest rates and optimize the performance of their investment portfolios. By employing spread positions, investors can mitigate risks associated with interest rate volatility while potentially enhancing overall returns. CME Group Yield futures act as an accurate risk management tool for expressing one’s view on the yield curve.
Exhibit 4: 2-10 Yield futures and 2-10 OTR spread (April 2023 to April 2024)
As can be seen in Exhibit 4 above, the 2-10 Yield futures spread and the 2-10 OTR spread closely track each other. The two spreads have a 0.99 correlation and have not differed by more than about 20 basis points within the past year.
To visualize movements in Treasury futures prices over time and compare those with both the BrokerTec U.S. Treasury Benchmark cash yields and constant maturity rates (par rates) published by the U.S. Department of the Treasury, visit the Treasury Analytics – CurveWatch tool from CME Group.
The 2-10 Treasury yield spread is a powerful indicator for analyzing economic conditions, interest rate expectations and investor sentiment. Its shape offers valuable insights into the state of the economy and can influence financial markets globally. By understanding the importance of this spread, investors can make more informed decisions, helping navigate uncertainties and capitalize on opportunities in the ever-changing economic landscape.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
