Thursday, August 26, 2010

Revisit on the 2s10s curve trade


Some readers send me comments on the relative value trade I posted yesterday. One of them opine that the 20+ year is a better bet. However, I disagree. 2s10s and 10s30s are driven by different fundamentals and their move can vary quite a bit. I believe the belly of the curve is the prime area to put on a flattening trade. The Fed on hold scenario has been priced in by the market, and it extends along the curve  from in to out . Meanwhile, the purchases of  Treasury from the payoffs of MBS and agencies are concentrated on the 5-10 sectors. Therefore, we need to pick this most juicy part of the curve.

Another reader ask me about the size of the trade, which is a great point worth mentioning. On a pure curve trade, the position should be duration neutral. In other words, the dollar duration of 2s and 10s of the trade needs to be the same. 2s duration is around 1.9, 10s duration is around 8 at current yield. Given that IEF's bond investments are in the 7-10 year sectors, the duration of it should be somewhere between 6-8. Today's market value of SHY and IEF are 84 and 99, respectively. So the unit ratio is approximately 4.4. In other words, you need to short 4.4 units of SHY for each unit long in IEF. When rate changes, the ratio will change as well due to the convexity of fixed income instruments. However, that won't be too big of a problem, the dollar duration match should get you the bulk part of  trade idea.

A step further is to express views on both the curve and the rates. My view is that the 10s rates can tank further to 2% level. For this bull flattening trade, you can long one unit of IEF and short less than 4.4 units of SHY, depending on your risk appetite. The less risk averse you are, the further away from 4.4 units you should be shorting. However, no matter what, remember to adjust the ratio back to approximately 4.4 after  we get clear signal that rates have hit the bottom.

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