In this article, we want to show you a trade in US government bonds. To make this trade, you need to understand and pay attention to the yield curve. Trading the yield curve is one of the most advanced methods.
Current yield curve in the US
The current picture of the yield curve in the US looks like this:
The individual interest rate differentials between the different maturities of US government bonds are very small. The reason is that the US Federal Reserve has steadily raised interest rates in recent months. This caused an increasingly flatter yield curve.
Historical classification of interest rate differentials
In the following overview you can see where the current interest differential level is classified historically:
To explain the overview, let’s pick out the first line: Here, the interest differential between two-year and five-year US government bonds is shown. The current interest rate differential is only 0.11%. This value represents only 17% of the total range of interest rate differentials over the past 30 years. You can also see the development of this specific interest rate difference in the following chart:
Trade the yield curve
We have decided to use this extreme area for our trading. To do this, we anticipate a widening of the interest rate differential between the two-year and five-year US government bonds. Unfortunately, you cannot trade interest rates but have to resort to government bonds. In principle, interest and price are opposites. If the interest rises, the price falls and vice versa. If you want to trade the yield curve and speculate on an increase in interest rate differentials, then you can do that as follows.
We’re betting on the interest rate differential between the two-year and five-year US government bonds widening again. This can happen in 3 different ways:
- both interest rates are rising, but the interest rates of the five-year government bonds are rising more
- both interest rates fall, but the interest rates on the two-year government bonds fall more sharply
- the interest rate of the two-year government bonds falls and the interest rate of the five-year government bonds rises
From a current perspective, scenario 1 is most likely. However, we will benefit from every scenario.
Building the trade
To construct the trade, we must consider the inverse relationship between price and interest. It is worth noting that you can learn more about this topic in our course.
If the interest rate on five-year government bonds rises, the price is likely to fall. So we have to bet on falling prices. As a counterpart, we are betting on rising prices in the two-year government bonds and creating a spread trade, also known as the TUF spread.
Pay attention to special features
Unfortunately, it is not that simple as described above. Both futures contracts have different multipliers. In addition, both futures contracts have different volatility. Due to all of these circumstances, it is necessary to determine an approximately similar IV-adjusted nominal value in order to carry out the trade in the correct ratio.
Our calculations use a ratio of approximately 3 to 2. We buy 3 futures contracts for the 2-year US government bonds and simultaneously sell 2 futures contracts for the 5-year US government bonds. In the pricing, the chart for this trade looks like this:
We currently want to buy this spread at 407 and are still waiting for the fill.
Crash as a bonus
Should there be a major stock market crash in the next few weeks or months, this trade is likely to benefit most. In the following chart, the last two crashes on the stock market are marked in red:
As a result, this trade is also a nice hedge for our equity investments in our Tradimo real money account, which currently stands at $126,000.
How can I quickly get notifications about such trades?
In our chat and signal community, you can immediately learn about our trades and discuss ideas and trades with us and other traders.