Chicago Board of Trade (CBOT) Treasury futures provide cost-effective and efficient means of capitalizing on anticipated changes in the shape of the yield curve. For example, recent upheaval in the slope of the Treasury yield curve suggests there may be opportunities to trade the TUT (tens under twos) spread, using CBOT 2-year and 10-year Treasury note futures.

The Current Market Context
The 2-year to 10-year segment of the on-the-run U.S. Treasury yield curve has steepened sharply this summer. From July 2 to July 23, the spread between the cheapest-to-deliver (CTD) 2-year and 10-year notes widened by 34 bps.  (The CTD and its impact on the TUT spread is discussed later in this paper).

With the Fed expressing determination to hold its fed funds target rate low for the foreseeable future, and with the U.S. federal deficit seeming to grow with each new report, at least some analysts have been calling for continued yield curve steepening.

If you expect the steepening to continue, you can capitalize on this outlook by buying the yield curve using CBOT 2-year and 10-year T-note futures. Note that with a futures strategy of this kind, you buy or sell the yield curve in terms of what you do with the shorter maturity futures contract.  Thus, if you anticipate a steeper yield curve (i.e., a widening yield spread), then you would buy the curve by buying 2-year Treasury note futures and selling 10-year Treasury note futures. Conversely, if you expect the yield curve to flatten (i.e., a narrowing yield spread), you would sell the curve by selling 2-year T-note futures and buying 10-year T-note future.

Structuring a TUT Spread
With a properly constructed TUT spread gains or losses on the spread should be the result of changes in the yield curve as opposed to changes in the direction of interest rates. To filter out this directional effect, you can ratio a yield curve spread using the dollar value of a basis point (DV01) for each contract to assure that each leg will respond equally, in dollar terms, to a given yield change.

On July 2, with 2-year T-note futures trading at 108-07+, this contract had a DV01 of $42.75. This indicates that a 1 bp shift in the yield of the underlying Treasury note will move the price of one contract $42.75 in the opposite direction. (Note that the CBOT 2-year T-note contract has $200,000 notional value, whereas other CBOT Treasury futures, including the flagship 10-year T-note contract, have $100,000 notional value.) With 10-year T-note futures trading at 117-13+, this contract had a DV01 of $70.61. A 1 bp shift in the yield of the underlying Treasury note will move the price of one $100,000 notional contract $70.61 in the opposite direction.

You can determine the appropriate ratio for this strategy by dividing the 10-year DV01 by the 2-year DV01. In this case, $70.61/42.75 = 1.66 contracts. That is, for every 100 10-year T-note contracts sold, you must buy 166 2-year T-note contracts to establish a DV01-neutral spread position. (For a more thorough discussion of the relationship between DV01s and modified durations, refer to the CBOT Treasury Futures Reference Guide, which is available online at www.cbot.com/ir.)

Possible Spread Results
This kind of ratioed spread should produce essentially no result if both yields change by the same amount. It should produce a significant gain only if the yield curve steepens, as it did during the July 2 to July 24 interval. The following chart shows how the spread would have performed.

The TUT steepens

Assume you had bought the TUT on July 2 in this 166-100 ratio. Note that the minus sign in the Number of Contracts column indicates the short leg of the spread. Exhibit 1 shows that from July 2 to July 24, the steeper TUT would have generated $279,188, not taking into account transaction costs. 

A Cautionary Note
This kind of spread should generate a positive result any time the yield curve changes in keeping with your forecast; however, this trade is speculative and will generate a loss if the spread narrows.

One factor that can affect spread trade performance is a change in the cheapest-to-deliver (CTD).  Each Treasury futures contract tracks the CTD issue, which may, or may not be, the on-the-run cash US Treasury. In other words, changes in the steepness of the cash curve may not correspond on a one-to-one basis with changes in the futures.  During the three weeks of this example, the CTD did not change for either the 2-year T-note or the 10-year T-note. But by the end of July the 10-year yield had changed enough such that the CTD shifted between three different issues.

In fact, anyone contemplating such a trade in mid-August will notice that the combination of rising yields and changing CTD status has altered the spread ratio to 197 contracts of 2-year T-note futures for each 100 contracts of 10-year T-note futures.

Efficient and Cost-Effective
TUT spreads are a practical way to take a position on your forecast of changes in the shape of the yield curve. Again, this spread will generate essentially no result in the case of a parallel yield curve shift. Furthermore, because TUT spreads implemented with CBOT Treasury futures receive margin credits, this kind of trade can be a low-cost means to capitalize on your yield curve outlook.

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.