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The Stagflation Hedge

Submitted by nickbarbon on 07/11/2009 00:05 -0400

The spread between the 2-year and 10-year points on the US yield curve has been unusually steep since May, when supply fears and convexity hedging caused a back up in rates. As the 10yUST backed up, the steepeness of the 2s10s curve reached a high of over 250 basis points. The same can't be said for forward curve spreads which have remained stubbornly flat. The 2s10s yield curve in swaps is currently ~222 basis points; meanwhile 1yForward is at ~150 and 2yrs forward is at ~87bps.

As the divergence between spot and forwards increases, more market participants are seeing forward curve steepeners as a way to capture and profit from a "low-for-long" + "deficit-/monetization-induced back up in long rates" scenario. While this stagflation hedge trade is a little tricky due to the carry component, hedgies and props are buzzing about the trade and executing it in vol space using curve options.

Here's the divergence in spot and 2yr forward swap curve steepeness:

2s10s

Here's the shape of the implied 2s10s curve in historical perspective (pre-June 2004 uses Treasuries rather than swaps):

2s10s implied

Mishkin's classic on yield curve steepeness here.

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Thu, 07/16/2009 - 09:28 | 7764 niamor

Nick,

Helps a lot, thanks for taking the time.

Thu, 07/16/2009 - 02:12 | 7707 Anonymous

Just buy some Red Eurodollars and do it the easy way chief

Thu, 07/16/2009 - 01:15 | 7694 nickbarbon

let's see if I can reformulate this a bit more clearly. The yield curve is a representation of the returns you can earn on bonds with different maturities (returns are based on bond coupons plus any discount/premium on the price of a bond at a given maturity). The most popular yield curve in the US is the Treasury yield curve, but there are also yield curves based on other types of instruments (for example interest rate swaps or credit default swaps). Here's a popular dynamic chart of the US Treasury yield curve. The shape of the yield curve, sometimes called a term structure, can take many forms. Often it is upward-sloping, meaning nearer maturities are lower than maturities further out. Other times it can be inverted, meaning longer maturities yield less than shorter maturities. This last case sometimes happens when the economy is getting into trouble and bond buyers believe that yields for short-dated treasuries are going to come down dramatically.

A curve steepener or flattener is simply a bet on the shape of the yield curve. It is expressed in basis points of difference between the longer maturity and the shorter maturity. You have to pick what part of the yield curve you're making a bet on (a popular section is the 2yr - 10yr part of the curve; hence the phrase 2s10s). You also have to pick the direction of said yield curve steepeness. For example, if you expect the 10yr part of the yield curve to increase in yield (sell-off), and/or the front-end 2yr point to drop in yield, you may want to put on a 2s10s steepener. You would do this by effectively going short the 10yr note and long the 2yr note. There are many reasons why you might want to take a view on curve steepness. Some are described nicely in this post.

So far we've been discussing today's yield curve, in real time. This is called "spot". There are also active markets in future treasury bonds and swaps, via forwards. Thus one can look at and evaluate the shape of not only today's 2s10s curve, but the 2s10s curve one year from now, two years etc..

The original post makes the point that forward yield curves are not nearly as steep as today's yield curve and some participants are seeing that as a cheap way to implement a view they have about the future path of short-term and long-term rates.

Hope that helps.

Thu, 07/16/2009 - 15:10 | 7952 Anonymous

Nick can you explain what trades goldman and morgan have on their IR swaps?...over 100 trillion of notional as of the last OCC update in March 09

If they have all of this leveraged risk ...1056% I can't imagine that they have taken the other side of rates going down futher so one would assume that they are going up ...can you see this in the market were can you see the activity relative to these disclosures...thanks for the post...

Thu, 07/16/2009 - 02:51 | 7712 Anonymous

That helps a ton, thank you!

Wed, 07/15/2009 - 23:13 | 7664 Anonymous

@Nick, watching seven digits of TLT & EDV take it on the chin over the past couple days, I too would like a more actionable read on your post. I think I get it, but the jargon's a bit thick.

Wed, 07/15/2009 - 20:42 | 7577 Anonymous

I will 5th, 6th, 7th, 8th, 9th, and 10th it.

Wed, 07/15/2009 - 19:07 | 7539 finan_learn

I 4th that!

Please explain this in layman's terms. This is too confusing!

Wed, 07/15/2009 - 18:52 | 7531 Going Loco

I have learned the hard way that if you can't explain something on the back of an envelope in words that my wife can understand you are probably a flim-flam man selling snake oil.

The biggest deal I was ever involved in WAS sketched out on the back of an envelope, everyone who was involved understood it, and it worked a treat.

Governments writing IOUs to themselves, money being conjured out of electrons at the whim of a central bank, exchange trading mostly carried out between computers fighting each other's algorithms - you don't need to be very bright to realise that the whole game has become a charade and it's best left alone.

Of course that doesn't help those of us with some money to decide what to do with it. I am going back to my original guess of 18 months ago - deflation or no deflation my cash is going to be worth nothing by the time this is all over. Time to spend it.

Wed, 07/15/2009 - 18:29 | 7511 Shaza (not verified)

Nick, for the uninitiated...If I hold 2 and 10's as part of a retirement fund....then what?

Sorry, very confused and I am not American! Can you please explain!

If you have a site to rec to get me up to speed, that would be appreciated too, trying hard to up the learning curve!

Wed, 07/15/2009 - 13:49 | 7330 surfer

Thanks for highlighting this, I wonder if its a function of the time value of the option. Im becoming increasingly convinced of Blacks option related view of the yield curve and the possible quantification of term premium through volatiity.

Wed, 07/15/2009 - 11:09 | 7273 Mazarin

Nick and Tyler, Stop showing off and explain what this post means for the non-bond savvy readers. ;-) Seriously, as the readership expands a great service can be done by pulling the curtain back a bit on fixed income complexities like skew, "convexity hedging", "non spot inflation capture" "barcap", "divergence between spot and forward" etc. I'm a King's finance minister and this stuff makes my head spin. Where is Fouquet when I need him to clarify? Ohh, in Pinerolo with Paulson and LB ;-)

Wed, 07/15/2009 - 16:11 | 7435 Anonymous

I'll second that.

Wed, 07/15/2009 - 18:25 | 7508 Shaza (not verified)

I third that!

Sat, 07/11/2009 - 13:14 | 6312 Tyler Durden

Isnt the fwd (especially 5 yr fwd) highly skewed? last i looked it was virtually flat. How much of this is non spot inflation capture do you think? I agree that the divergence technicals are due for a pull back at some point. How much net/notional do you think has been put to use in this trade (i.e. if there is a snapback how violent will it be?)

Tue, 07/14/2009 - 20:38 | 7074 nickbarbon

No real good sense for size. BarCap has continued to publish on this trade - Orange County 1994 is just a distant memory now.

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The Stagflation Hedge

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