Curve Trades
Trading the shape of the yield curve - steepeners, flatteners, and the art of relative value.
The Trade That Made and Broke Fortunes
In January 2021, "steepener" was the most crowded trade on Wall Street. Buy 10-year Treasuries, sell 2-year Treasuries (duration-weighted). The thesis: vaccines and stimulus would drive growth, pushing long-end yields higher relative to the Fed-anchored front end.
The trade worked beautifully - for exactly 10 weeks. 2s10s spread exploded from 80bps to 160bps. Traders who had positioned early made millions. Then the Fed pivoted hawkish, the curve reversed, and many of those same traders gave it all back and more.
This is the nature of curve trades: they can generate enormous profits when you get the shape right, but they require impeccable timing and careful position sizing. Unlike directional bets, curve trades are about relative value - you are betting on how two points on the curve move relative to each other, not on the absolute level of rates.
The key insight: A duration-neutral curve trade does not care if rates go up or down 100bps. It only cares if the spread between the two tenors changes.
Learn From History
Every curve trade environment teaches different lessons. Select a period to study:
The Reflation Steepener
The Setup
COVID vaccines rolling out. Massive fiscal stimulus passed. Inflation expectations surging. The "reflation trade" was the consensus: buy 10Y, sell 2Y (duration-weighted). Everyone expected the curve to steepen as growth returned.
What Happened
The trade worked spectacularly for weeks. 2s10s spread widened from 80bps to 160bps. Long 10Y positions gained on roll-down and carried positively. Then came the trap.
When Steepeners vs Flatteners Work
Steepeners Work When...
- Economic recovery: Growth expectations push long yields higher while Fed holds short rates
- Inflation rising: Long-end reprices for higher inflation, front end anchored by Fed
- Fed cutting cycle: Front end rallies faster than long end as Fed eases
- Supply concerns: Fiscal deficits push term premium higher on long bonds
Classic setup: Post-recession 2009-2010, post-COVID 2021. Steepeners worked as economy recovered from crisis.
Flatteners Work When...
- Fed hiking cycle: Front end sells off as Fed tightens, long end stable on growth fears
- Recession fears: Long-end rallies as safe haven, front end sticky on Fed policy
- Risk-off episodes: Flight to duration pushes long yields down
- Peak inflation: Long end anticipates disinflation, front end still fighting current inflation
Classic setup: Fed hiking cycles 2022, 2017-2018, 2004-2006. Flatteners profited as policy tightened.
Duration-Weighted Trade Construction
The critical insight in curve trading: you must match DV01, not notional. A 10-year bond has roughly 5x the duration of a 2-year bond. If you want to be neutral to parallel rate moves, you need 5x more notional on the 2-year leg.
Building a 2s10s Steepener
Long 10Y, Short 2Y (duration-weighted to be rate-neutral)
With matched DV01s, a 50bp parallel shift in rates produces -$0 P&L - nearly zero. But a 30bp steepening (10Y up 15bp, 2Y down 15bp) produces significant curve profit.
P&L Attribution: Curve vs Parallel
Understanding where your P&L comes from is essential for managing curve positions. Every move can be decomposed into:
Parallel Shift
All rates move equally. On a duration-neutral trade, this should be ~zero.
Curve Change
Spread between tenors changes. This is your profit engine.
Carry & Roll
Daily income/cost from holding the position plus roll-down effects.
Build Your Curve Trade
Trade Legs
Combined Position
Payoff Profile
P&L across parallel yield curve shifts (all tenors move equally):
Risk Summary
Position is short duration ($-1K DV01). Profits when rates rise, loses when rates fall.
Significant curve exposure between 2Y and 10Y. Sensitive to steepening/flattening.
Trade Examples (Simple)
Three concrete curve trade scenarios explained plainly:
Example 1: The Steepener
You buy $10M of 10Y Treasuries (DV01 = $8,500) and sell $50M of 2Y Treasuries (DV01 = $8,500). Net DV01 = ~$0. You are duration-neutral but long the 2s10s spread.
Long 10Y: Finance via repo at 4.3%, post $500K margin. You earn 4.4% coupon, pay 4.3% repo = small positive carry. Short 2Y: Borrow bonds in reverse repo, sell them. You receive repo rate on cash proceeds but owe coupon. Net: depends on curve shape. On a steep curve, long leg carry > short leg cost.
2s10s spread widens from 20bps to 50bps. 10Y yield rises 10bps, 2Y yield falls 20bps.
10Y loss from 10bp rise: -$85K. 2Y gain from 20bp fall on short: +$170K (you sold high, now can buy back lower). Net: +$85,000. Curve steepened, you profited.
You bet the 10Y would underperform the 2Y. The spread widened 30bps and you made $85K. Note: you did not care that rates moved overall - only that the relationship between 2Y and 10Y changed.
Example 2: The Flattener
You sell $10M of 10Y Treasuries and buy $50M of 2Y. Opposite of steepener. Net DV01 = ~$0. You profit if the curve flattens (2s10s spread narrows).
Short 10Y: Borrow bonds in repo, sell them. You receive cash, invest at repo rate. You owe coupon to lender. Long 2Y: Buy bonds, finance in repo. On inverted curve (2022-2023), short 10Y paid positive carry because you earned more on cash than you paid in coupon. Long 2Y cost you.
Fed hikes aggressively. 2Y yield shoots up 100bps, 10Y only up 50bps. Curve flattens 50bps.
Short 10Y gains from 50bp rise: +$425K (sold high, buy back low). Long 2Y loses from 100bp rise: -$170K. Net: +$255,000. Flattening paid.
During Fed hiking cycles, the front end sells off harder than the long end. Flatteners capture this. In 2022, flatteners were the winning trade as 2s10s went from +40bp to -80bp.
Example 3: The Twist
You put on a 2s10s steepener AND a 10s30s flattener. You are betting the belly (10Y) underperforms both wings. This is a "twist" or "butterfly-adjacent" trade.
Complex multi-leg. Long 2Y and 30Y, short 10Y. Each leg financed in repo. Net DV01 can be calibrated to any level. Carry depends on curve shape at each point. Often used when you think the 10Y is mispriced relative to neighbors.
2s10s steepens 15bps (good for first leg). 10s30s flattens 10bps (good for second leg). Both trades work!
Steepener: +$40K. Flattener: +$25K. Total: +$65,000 from curve reshaping.
Sometimes you have a view on multiple curve relationships. This trade profits when the 10Y "kinks" - underperforming both the 2Y and 30Y. Common after auctions or during risk-off when duration demand shifts curve shape.
Funding Context: Repo and Reverse Repo
Curve trades involve both long and short positions. Understanding how each leg is financed is crucial for calculating true carry.
Financing the Long Leg (Repo)
Net: Earn spread between coupon and repo rate. On steep curve, this is positive.
Financing the Short Leg (Reverse Repo)
Net: Earn repo on cash minus coupon you owe. On inverted curve, short carry can be positive!