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Yield Curve Conundrum

The 10 year 2 year treasury spread is often used to measure the steepness of the yield curve.  When the curve is very steep it either shows that expectations of growth and inflation are high in the future, that the Fed is keeping the front part of the curve artificially low, or some combination of the two.  What is truly interesting with this latest announcement of quantitative easing through an additional $600B of purchases is that the yield curve decreased on the front end and remained fairly stable at longer maturities.  In fact, the spread between the 10 year and 5 year treasury rates is hitting historic highs:

10 Year Rates are low, but not Compared to the 5 Year!

At first glance this is not a very exciting 1.5% spread because the 10 year is at 2.5% and the 5 year is basically at 1%. What does get interesting is when you look at the forward interest rate curve, or the future expectations of interest rates as predicted by the shape of the yield curve.   With the 5 year swap rate at 1.3% and the 10 year swap rate at 2.61%, the yield curve is saying that the 5 year swap rate in 5 years will be 4.12%!  At today’s rates, entering into a forward starting interest rate swap actually looks rather attractive.  If you are happy buying 5 year bonds today at 1.3%, then you should be pretty excited to lock in a 5 year rate in 5 years of 4.12%.  You might just say that buying a 10 year bond today would achieve the same exposure, but in that situation you are buying a compilation of the 1.3% rate and the 4.12% forward rate, so why not just buy twice the amount of the forward rate?

Would you lock in a 5 Year Swap for over 4%?!

Another way to look at this from a trading perspective is to strictly play the spread between the 10 year and 5 year.  Spreads generally revert to some sort of average, so I would be inclined to suggest that going long a ten year treasury futures contract and short two five year treasury futures contracts (nearly duration neutral) has a high probability of paying off.

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