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A 'Don't Fight the Fed' Yield Curve Update

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Here are some insights into spread trading strategies and how to read spread charts, especially as related to the Fed's zero interest rate policy.

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Trading Interest Rate Spreads

The Spread Trading Setup: The long end of the Treasury curve has been showing signs of being under selling pressure for the past couple months. And this has translated to trend reversals in the underlying Treasury spread trades. Two of the more common spread trades I follow are the "Tuts" (twos – tens spread) & the "Fyts" (5 vs. 10 spread). There are other spreads of different duration, but for trading purposes I have found that trading these two in conjunction is a balanced way of getting "bang for your buck" while "controlling volatility risk." You can duplicate these spreads in the eurodollar market (and arbitrage the two as well), but I'll save that subject for another post.

The below daily chart is the Twos-Tens adjusted for DVO1 risk.



You can clearly see that the TUT has broken primary trend line and is showing minor waves of higher highs and higher lows. To me, this is the primary spread duration that often leads the direction of other shorter duration spreads. So since my expectations are for the TUT to continue higher, I am actively looking to "buy the dip" in the First Trust Exchange-Traded AlphaDEX Fund (NYSEARCA:FYT) (long 5-year Treasuries – short 10-year Treasuries) – betting that the difference, or curve, in the yield between the two will increase. Since there is a directional component of this spread I am actively looking for trades only in the direction of the underlying trend. And similar to any other trade, I use a clearly defined stop losses and targets.

Under the Hood

Some of the best tools I have found for timing my spread trades are:
  1. Price Bands: Bollinger, Volatility, Envelopes & Projection.
  2. Value Charts: Developed by Mark Helweg & David Stendahl
You can see in the example shown below (FYT spread trading chart) that waiting for the spread to eclipse the bands, coupled with an Oversold reading on the value chart provides for a pretty accurate entry point.



What I really like about this particular type of trading is that it offers many flexible options for shifting your trade as the market develops. One example would be if during the undulations of the spread I feel that another Treasury future of different duration might offer better probability, I can simply leg out of one side of my current spread and replace it with a different leg (i.e. roll fyts into tufs = buying back short 10-year leg and selling 2-year Treasuries).

Hopefully this didn't fly over too many people's heads, and thanks for reading!

This article by Alex Bernal was originally published on See It Market.
No positions in stocks mentioned.
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