A noticeable feature of the U.S. yield curve this year has been the sharp steepening, regardless of the tenor one considers. The chart above shows the most common view, which is the 2-year vs. 10-year yield curve. One can see that the curve has steepened by over 150 basis points from the lows. Looking back through time, steepening periods of more than 100 basis points have led to recessions, which one can see from the red shaded areas of the chart. The question then becomes whether this is a bull steepening, where bonds are rallying and yields are heading lower, but where the 10-year yield falls slower than the 2-year, or a bear steepening, where bonds are selling off with yields rallying but where 10-year yield rallies faster. In reality, it has been more of a unique steepening of the curve, as the 10-year yield has rallied from the lows even as the Fed is lowering short-term interest rates and the 2-year yield moves lower reflecting the market expectation that the Fed will continue to lower interest rates.

With the different parts of the bond market perhaps responding to different drivers right now, it is worthwhile to understand why the bond market may be expressing such a bearish economic view as is seen by the falling 2-year yields. The chart here shows 2-year yields have fallen to 3.78%, suggesting more than two more rate cuts, in addition to the four rate cuts the FOMC has already delivered, over the next two years. Why so bearish? The custom index I created by taking the difference of the Conference Board current situation less the Conference Board future expectations may be telling. Respondents to the poll feel that their current situation is quite good, with a reading well above 100 and stronger than the previous month. However, when asked about what they think will happen in the future, this number halves to 60. We see this difference of almost 62 is among the highest readings we have seen this century. However, it is similar to what consumers have felt in the post-Covid world. Perhaps there is some surprise that the current situation is fine, but the expectations of the future have remained bleak. The bond market is seizing on this bearish outlook and expects the FOMC to cut rates. Is this realistic?

In order to determine just how the market thinks the FOMC may lower rates over the next two years, traders can turn to FedWatch from CME Group, which calculates the conditional probabilities of rates at each level using the Fed Funds options market. Looking toward the back half of 2026, we can see that the central tendency for the Fed Funds rate is expected to land somewhere in the 3-3.5% range. With the current Fed Funds level of 4.33%, this would potentially be about four more rate cuts over this time horizon. With current 2-year yields at 3.78%, this also suggests the potential for more downside in yields over this time period.

Turning to the charts, I show both the technical chart of the 2-year yield and the 2-year futures, knowing one is an inverse of the other. I find it interesting to see if both the yields and the futures are giving the same signal, since I use the generic front month futures, this signal is now always the same. In the top chart, we see that the 2-year yield has consistently failed and the 200 day moving average has a very bearish set-up. Eyeing a move back to the lows seen in September 2024 and earlier this year at 3.4%, it is not surprising in the range of where the market thinks Fed Funds futures may get to over the next couple of years. One might think that futures have a very bullish setup. However, this isn’t what I see when I look at the Ichimoku chart of the 2-year futures. In fact,  the price is solidly in the middle of the Ichimoku Cloud, suggesting some indecision in the market. In addition, the cloud itself is flat here again suggesting no trend and a difference of opinion of what may happen going forward. If anything, the lagging span (red) is falling below the cloud, which is actually a signal that the trend may be resolving lower for the cloud. This would be bearish for futures and bullish for yields. Thus, whether we look at yields or futures, we may have a different opinion on rates over the next two years.

Turning to the volatility market, we see that in spite of the indecision, the options market doesn’t really seem to care. CVOL levels for 2-year futures are near the lows of the last three years suggesting there is not a lot of hedging or directional interest in using the options market. Perhaps this is because, or why, the futures themselves are showing indecision. The options market is saying “nothing to see here folks.” Within the options market, there has been some relative preference for upside versus downside options. However, we see this in the skew ratio, the ratio of upside volatility to downside volatility, which has risen from a level of 1 (no difference) to 1.4 (stronger demand for upside). This is near the highs of the last three years. While the overall level of volatility is perhaps giving an opportunity because it is so low, suggesting little demand, we can see that where there is demand for options, it is on the upside of the market, looking for futures to breakout higher and yields to fall further.

Further looking into the internals of the options market, I want to look at the term structure of implied volatility and the volatility surface. These views will tell me which expirations see relative demand versus supply and which deltas within an expiration are showing relative demand versus supply. While in the very short dates at the left part of the term structure there is a lot of variability, these have weekends and holidays impacting volatility levels. Once we move past the Fourth of July holiday, we can see the term structure is reasonably flat from July 8 to July 12.

In the bottom chart, there is a lot of granularity across the various expirations. Given there are now Tuesday and Thursday expirations in the 2-year market, giving traders daily expirations to focus on, traders can really see where exactly traders want to place their bets, highlighting potential market catalysts. When there is no particular difference, we can infer that traders don’t see events as a potential catalyst that will change the opinion of bulls or bears. We can see by comparing the VT1N5 and HT2N5 contracts that there is little difference in volatility between these expirations, suggesting that the market doesn’t see much potential for market moving news. While this may be the case, if in fact this deadline has even a fraction of the volatility of Liberation Day, it may well be worth owning options around the event, particularly as the overall level of volatility is near three year lows. Recall that on Liberation Day, 2-year yields fell to 3.4% before recovering. Could this type of move happen again in a futures market that is showing no particularly strong directional view or trend?

Putting this information together, the trade that may set up the best is a call calendar. Traders may opt to simply buy calls looking for an upside move. However, there is a risk of loss of premium. If the market is quiet for the next few days, which is reasonable given the Fourth of July holiday, traders will not pay time decay. If the VT calls expire worthless, traders will be left long 104.125 TU calls, with implied volatility near three-year lows, a futures market that is consolidating and could breakout, and a potential catalyst that took futures well above the 104.125 strike back in April. If there is a large move lower in futures between now and the expiration of the first contract, both options likely expire worthless, and the trader will lose the net premium of about 10 ticks versus losing 46 ticks if only buying calls outright or potentially more if buying futures. If futures rally sharply before the expiration of the first contract, the short 104.125 calls will be assigned, and the trader will be left short futures versus long calls. Traders may choose to reduce some of the delta and run the calls on a delta neutral basis, making a short-term volatility play around the catalyst, again with implied volatility at three-year lows. If futures move enough that both options are deep in the money, they will both expire worth about the same and the trader will be out the net premium again. The best case scenario is a steady drift up toward, but not through, the strike of the calls. The first contract expires worthlessly and now a trader is left long a roughly at-the-money call for a very low premium. They may choose to sell it and take profit or hold it for the catalyst.

The flexibility of daily expirations gives traders great flexibility in expressing bespoke views around potential market catalysts. Combined with the tools to analyze what is priced in and where the opportunity may be, CME Group gives traders all they need to be effective in trading for market-moving events.

Good luck trading!

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