Treasury Intermarket Spreads - The Yield Curve

Once you understand how to calculate the basis point value (BPV) of a U.S. Treasury futures contract and dollar-weighted hedge ratios versus other fixed income securities, it is short walk to how to spread one contract versus another.

A spread trade is one where the trader buys one and simultaneously sells another highly correlated futures contract. Spreads can be intra-market, like a time spread, also known as a calendar spread, buying one month and selling another of the same product. Or spreads can be constructed between similar products like buying corn and selling wheat.

Within the U.S. Treasury futures complex it is very common to spread one U.S. Treasury contract against another. Because CME Group lists multiple U.S. Treasury futures based on targeted maturities (2-year, 5-year, 10-year, Ultra 10-year, Bond and Ultra-Bond) traders can construct spread trades to express a point of view on the slope of the yield curve.

U.S. Treasury securities are traded based on price,  but also reflect a corresponding yield-to-maturity (YTM). If you were to take all of the government securities and plot them on a grid with the x-axis showing their maturity dates and y-axis showing their yield-to-maturity you would end up with what looks like an upward sloping pattern left to right.

The grid of yields versus maturity is known as the U.S. Treasury yield curve, or simply the yield curve, . Normally quoted using the most recently auctioned U.S. Treasury securities called on-the-runs (OTR), the yield curve expresses the yield difference between various points along the curve.

For example, one frequently quoted yield spread is the difference between the 2-year note and 10-year note. If you were told the 2/10 yield curve was 150 basis points that would generally mean the yield of the 10-year was 150 basis point higher than the yield of the 2-year note.

Yield curves can be positively sloped, flat or negatively sloped (inverted). When a trader or risk manager places a yield curve trade she is more concerned with the relative value, or difference in yields, between the securities than whether absolute yields rise or fall.

Traders can and do express opinions on the U.S. Treasury futures yield curve by spreading one U.S. Treasury futures contract versus another. Looking back at the 2/10 spread mentioned above, a similar trade could be constructed using futures contracts.

The spread begins with what we already know about U.S. Treasury futures, they trade like their CTD securities and we can calculate their implied BPV.

If we wanted to buy a 2/10 yield spread using futures, we must first identify which U.S. Treasury futures contracts we want to use to build the spread. We know there is a 2-year futures contract but what about the 10-year side?

There are two futures contracts listed by CME Group that derive their value from 10-year U.S. Treasury securities, the Classic 10-Year and the Ultra 10-Year. Which should we use? The Ultra-Ten Year tracks a CTD that trades closer in maturity to the OTR 10-year so we will use it for our example. So for our example we would buy the 2-year future and sell the appropriate number of Ultra 10-Year futures.

The second step is to identify each contract’s CTD issue, then, based on its CTD’s BPV and conversion factor, calculate each contract’s implied BPV. Then we can compare the respective BPVs and, with a little math, arrive at the appropriate spread ratio (SR). Mathematically it would look like this:

Spread Ratio (SR) = BPVultra-ten ÷BPV2-year

Assume that the 2-Year (TUH7) has a BPV of $46.25 per contract and the Ultra  10-Year (TNH7) has a BPV of $128.78. Plug this into the formula above and we get:

SR= 128.78 ÷ 46.25 = 2.78, or roughly 3:1 TUH7 to TNH7

By buying three TUH7 contracts versus one TNH7, this spread is effectively dollar-neutral. That means it is less subject to profit and loss based on direction of the market and more subject to change in the yield difference between the contracts. This trade is about changes in slope rather than changes in outright yield. Because U.S. Treasury futures prices move in an inverse relationship to yield, if one is buying the 2/10 they are anticipating the slope to steepen, or increase, between 2/10s.

We recognize traders and risk managers utilize U.S. Treasury futures to trade the slope of the yield curve and conveniently list yield curve trades weighted and rounded to whole number ratios on our website and on CME Globex.

Yield curve trades are a common and frequently executed trade in both cash and futures U.S. Treasury markets. They can provide added value to risk managers and traders alike. Understanding the pricing and trading behavior of CME Group U.S. Treasury futures contracts and how they relate to the underlying cash Treasuries is essential to using them effectively.