Curve Steepener Trade

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.

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.

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 strategy known as the 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 to 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.