Introducing BrokerTec RV Curve

After several quarters of relative calm, the U.S. Treasury yield curve has become much more active in early 2021.  The Federal Open Market Committee continues to hold the very short end of the yield curve near zero, but recently the longer end has recovered from its historic lows, and cash Treasury volatility has returned.

These events have increased the need for efficient hedging across the curve, which BrokerTec’s RV Curve pairs enable at convenient ratios, transparent price levels, and reduced execution risk.

Intro

The latter half of 2020 saw a cooling of interest rate volatility, with rock-bottom rates and minimal changes in Fed policy expected. However, in early 2021 a bifurcation in the yield curve has become apparent. The short end of the curve remains flat, held down by Fed policy, while long term yields have seen a dramatic rise, perhaps an indication that unprecedented government debt issuance has begun to saturate demand.

 

This tension at each end of the US Treasury curve has focused attention on the relative value trade, with hedgers looking to insulate themselves from changes in steepness, and liquidity providers keen to capture dislocations along the curve. To make this easier, BrokerTec recently launched the RV Curve offering on Globex,1 allowing for efficient execution of fixed pairs with no need for legging of individual Treasuries.

Along with removing legging risk, RV Curve leverages CME’s implied order functionality, bridging the trading in the RV curve spreads with liquidity available in the outright orderbook. This means that each leg of the RV order can be executed within BrokerTec’s liquid, central limit order book, alongside outright orders to increase matching opportunities at a set price compared to executing each leg of a curve trade individually.

Yield Curve Trends

In Q1 2020, the economic slowdown saw anticipation of target rate cuts in March, before the pandemic response-driven economic contraction prompted aggressive action by the FOMC. Target rate cuts of 50 and 100 basis points pushed the front half of the yield curve from around 1.5% at the start of the year, to around 1% at the start of March, to 0.1-0.4% by April, as the pandemic response drove the entire curve down 125-140 basis points – shown in gray and purple in the following exhibit.

By early 2021, tenors below the 5-year point had shown little movement, but from the 7-year point out a rotation of 25-35 basis points upward had begun. By March 2021 the 20- to 30-year range had returned almost to January 2020 levels, a rally of nearly a full percentage point – shown in purple and blue below.

Source: CME Group

The steeper curve created by this rotation is viewed by some in the market as a more normal state following an extended period of flatness, but it remains to be seen whether the upward pressure will move down the curve toward the short end. For now, market participants are finding prices in the front end “sticky” and have expressed strong support for easier execution into and out of RV positions.

RV Curve Pairs

RV Curve consists of each combination of US Treasuries offered by BrokerTec: 2-year, 3-year, 5-year, 7-year, and 10-year Notes; as well as 20-year and 30-year Bonds. Each has a symbol indicating its two instruments and a long name which also indicates its ratio. For example, the “5Y/10Y 2:1” consists of a 5-year quantity of 2 million and a 10-year quantity of 1 million.

Long Name Symbol Front Leg Back Leg Leg Ratio Front Quantity (MM) Back Quantity (MM)
2Y/3Y 3:2 UB2:03 2Y 3Y 1.67 3 2
2Y/5Y 5:2 UB2:05 2Y 5Y 2.50 5 2
2Y/7Y 3:1 UB2:07 2Y 7Y 3.33 3 1
2Y/10Y 5:1 UB2:10 2Y 10Y 5.00 5 1
2Y/20Y 10:1 UB2:20 2Y 20Y 10.00 10 1
2Y/30Y 10:1 UB2:30 2Y 30Y 10.00 10 1
3Y/5Y 3:2 UB3:05 3Y 5Y 1.67 3 2
3Y/7Y 2:1 UB3:07 3Y 7Y 2.50 2 1
3Y/10Y 3:1 UB3:10 3Y 10Y 3.33 3 1
3Y/20Y 5:1 UB3:20 3Y 20Y 5.00 5 1
3Y/30Y 8:1 UB3:30 3Y 30Y 10.00 8 1
5Y/7Y 3:2 UB5:07 5Y 7Y 1.43 3 2
5Y/10Y 2:1 UB5:10 5Y 10Y 2.00 2 1
5Y/20Y 3:1 UB5:20 5Y 20Y 3.00 3 1
5Y/30Y 4:1 UB5:30 5Y 30Y 5.00 4 1
7Y/10Y 3:2 UB7:10 7Y 10Y 1.43 3 2
7Y/20Y 2:1 UB7:20 7Y 20Y 2.00 2 1
7Y/30Y 3:1 UB7:30 7Y 30Y 3.33 3 1
10Y/20Y 2:1 UB10:20 10Y 20Y 1.67 2 1
10Y/30Y 2:1 UB10:30 10Y 30Y 2.50 2 1
20Y/30Y 3:2 UB20:30 20Y 30Y 1.33 3 2

Direction is indicated by the front leg, so buying the UB5:10 means buying the 5-year and selling the 10-year. The minimum price increment matches the smallest outright tick size at ⅛ of 1/32nd, with the price quoted in basis points indicating the yield difference between the front and back legs, ie, -50 for a 50bps lower yield in the front leg than in the back.2

Leg ratios are derived from DV01-neutral hedges, simplified for easier trading and position tracking. Where appropriate, ratios were rounded to simpler combinations – that is, back legs as close to 1 as possible. This is similar to the convention followed for CBOT Treasury Futures Inter-Commodity Spreads.3

Outright Leg 2-year 3-year 5-year 7-year 10-year 20-year 30-year
2-year   3:2 5:2 3:1 5:1 10:1 10:1
3-year 3:2   3:2 2:1 3:1 5:1 8:1
5-year 5:2 3:2   3:2 2:1 3:1 4:1
7-year 3:1 2:1 3:2   3:2 2:1 3:1
10-year 5:1 3:1 2:1 3:2   2:1 2:1
20-year 10:1 5:1 3:1 2:1 2:1   3:2
30-year 10:1 8:1 4:1 3:1 2:1 3:2  

Which Way, Yield Curve?

While the volatility spike of March 2020 was short-lived, more recent measures point to the possibility of sustained uncertainty in the shape of the curve, even as policy rates remain unchanged. The tension which created the bifurcation between a flat front end and a rising back end is not likely to go away.

Historically, volatility increases such as those seen in the long bonds have accompanied similar rises in the short end notes, but so far, the very front of the curve has remained quiet, with the 2-year in the 0.2-0.3% range. This contrasts with bond volatility into the double digits.

One additional wrinkle is the 20-year’s yield premium (price discount), relative to values extrapolated from the 10- and 30-year points. While this was anticipated following its reintroduction in Q2 2020, it was reasonable to expect it would be priced out as the 20-year became an established liquidity point.

Source: CME Group

Instead, the recent rally made the kink more pronounced, from a premium of 12-16 basis points throughout 2020 to 26 bps in March 2021.

These dynamics point to continued distortions in yields at different tenors, which BrokerTec’s RV Curve pairs will be essential to help manage in an efficient manner.

References

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