What Is a Curve Steepener Trade?
A curve steepener trade is a strategy that uses derivatives to benefit from escalating yield differences that occur as a result of increases in the yield curve between two Treasury bonds of different maturities. This strategy can be effective in certain macroeconomic scenarios in which the price of the longer-term Treasury is driven down.
Key Takeaways
- Curve steepener trades benefit from rising yield differences as a result of an increase in the yield curve of two T-bonds of different maturities.
- A yield curve is a graph of the bond yield of various maturities.
- If the yield curve steepens, this means that the spread between long- and short-term interest rates increases—i.e. yields on long-term bonds are rising faster than yields on short-term bonds.
- A steepening yield curve indicates that investors expect stronger economic growth and higher inflation, leading to higher interest rates.
- The curve steepener trade involves an investor buying short-term Treasuries and shorting longer-term Treasuries.
Understanding Curve Steepener Trades
The yield curve is a graph showing the bond yields of various maturities ranging from 3-month T-bills to 30-year T-bonds. The graph is plotted with interest rates on the y-axis and the increasing time durations on the x-axis. Since short-term bonds typically have lower yields than longer-term bonds, the curve slopes upwards from the bottom left to the right. This is a normal or positive yield curve.
Sometimes, the yield curve may be inverted or negative, meaning that short-term Treasury yields are higher than long-term yields. When there is little or no difference between the short-term and long-term yields, a flat curve ensues.
The difference between the short-term and long-term yield is known as the yield spread. If the yield curve steepens, this means that the spread between long- and short-term interest rates increases. In other words, the yields on long-term bonds are rising faster than yields on short-term bonds, or short-term bond yields are falling as long-term bond yields are rising. When the yield curve is steep, banks are able to borrow money at a lower interest rate and lend at a higher interest rate.
An example of an instance where the yield curve appears steeper can be seen in a two-year note with a 1.5% yield and a 20-year bond with a 3.5% bond. The spread on both Treasuries is 200 basis points. If after a month, both Treasury yields increase to 1.55% and 3.65%, respectively, the spread increases to 210 basis points.
How and When to Use a Curve Steepener Trade
A steepening yield curve indicates that investors expect stronger economic growth and higher inflation, leading to higher interest rates. Traders and investors can, therefore, take advantage of the steepening curve by entering into a curve steepener trade.
The curve steepener trade involves an investor buying short-term Treasuries and shorting longer-term Treasuries. The strategy uses derivatives to hedge against a widening yield curve. For example, an individual could employ a curve steepener trade by using derivatives to buy five-year Treasuries and short 10-year Treasuries.
One macroeconomic scenario in which using a curve steepener trade could be beneficial would be if the Fed decides to significantly lower the interest rate, which could weaken the U.S. dollar and cause foreign central banks to stop buying the longer-term Treasury.
This decrease in demand for the longer-term Treasury should cause its price to fall, causing its yield to increase; the greater the yield difference, the more profitable the curve steepener trade strategy becomes.
What Is the Difference Between a Bullish and Bearish Steepener?
A bear steepener is utilized when the market is expected to experience increased inflation and, therefore, an increase in interest rates by the Fed to stem inflation. Bull steepeners are the opposite, utilized when interest rates drop and the market is expected to grow.
What Is the Difference Between a Flat and Steep Yield Curve?
A normal yield curve shows increasing yields with increasing maturity. A flat yield curve would show similar yields across all maturities, which indicates economic uncertainty. A steep yield curve is a signal of very strong economic growth, which would usher in increased inflation and higher interest rates.
How Do You Trade a Bull Steepener?
To trade a bull steepener you would buy short-term bonds and sell long-term bonds. When the difference between short- and long-term interest rates widens, you would earn more money on the short-term bonds than the money lost on the long-term bonds.
The Bottom Line
Traders can take advantage of the curve steepener strategy by using derivatives on two T-bonds of different maturities. When there are shifts in the economy, there are opportunities to make a profit. Traders would implement a curve steepener when there are macroeconomic events that will stimulate the economy with the expectation of inflation.
