Curve Trades (Steepeners/Flatteners)
Trading the shape of the yield curve with steepeners and flatteners
Curve Trades (Steepeners/Flatteners)
Curve trades are among the most widely used strategies in the JGB market. Unlike simple directional bets that profit from parallel shifts in the yield curve, curve trades are designed to profit from changes in the shape of the yield curve—specifically, whether it steepens or flattens.
What are Curve Trades?
A curve trade involves taking simultaneous long and short positions at different maturity points on the yield curve. The strategy is constructed to be duration-neutral, meaning it has minimal exposure to parallel shifts in interest rates. Instead, it profits purely from changes in the spread between two points on the curve.
The two main types of curve trades are:
- Steepener: Profits when the yield curve steepens (spread widens)
- Flattener: Profits when the yield curve flattens (spread narrows)
Example: 2s10s Spread
The most commonly traded curve spread in JGB markets is the 2s10s spread—the difference between 10-year and 2-year yields.
- Current market: 2Y JGB yields 0.20%, 10Y JGB yields 0.80%
- 2s10s spread: 0.80% - 0.20% = 60 basis points
A steepener trade would profit if this spread widens (e.g., to 70bp). A flattener trade would profit if this spread narrows (e.g., to 50bp).
Why Trade the Curve?
Curve trades are popular because they allow investors to:
- Express views on monetary policy: Expectations about BOJ policy changes often affect different maturities differently
- Hedge interest rate risk: Duration-neutral construction protects against parallel shifts
- Exploit mean reversion: Curve spreads tend to fluctuate around long-term averages
- Reduce directional risk: Lower volatility than outright long/short positions
Duration-Neutral Construction
The key feature of a curve trade is that it’s constructed to be duration-neutral (or DV01-neutral). This means the position has zero sensitivity to parallel shifts in the yield curve.
To achieve this, we need to balance the DV01 of the long and short legs:
\[\text{DV01}_{long} = \text{DV01}_{short}\]Or more specifically:
\[\text{Notional}_{long} \times \text{DV01}_{long} = \text{Notional}_{short} \times \text{DV01}_{short}\]This leads to the weight ratio:
\[\text{Weight Ratio} = \frac{\text{Notional}_{long}}{\text{Notional}_{short}} = \frac{\text{DV01}_{short}}{\text{DV01}_{long}}\]Where:
- $\text{Notional}_{long}$ = Face value of the bond you’re buying
- $\text{Notional}_{short}$ = Face value of the bond you’re selling
- $\text{DV01}$ = Change in bond value for 1bp yield change (see Section 5.3)
Steepener Trade: Detailed Example
Let’s construct a 2s10s steepener position with ¥5 billion notional exposure.
Market Setup:
- 2Y JGB #500: Yield 0.20%, Price 100.15, DV01 = ¥1,950 per ¥1bn
- 10Y JGB #362: Yield 0.80%, Price 99.85, DV01 = ¥9,200 per ¥1bn
- Current 2s10s spread: 60bp
Trade View: We believe the BOJ will eventually normalize policy, causing long-end yields to rise more than short-end yields (curve steepening).
Step 1: Determine Position Sizes
For a duration-neutral steepener, we:
- Buy (go long) the 10Y JGB
- Sell (go short) the 2Y JGB
Using the weight ratio formula:
\[\frac{\text{Notional}_{10Y}}{\text{Notional}_{2Y}} = \frac{\text{DV01}_{2Y}}{\text{DV01}_{10Y}} = \frac{1,950}{9,200} = 0.212\]If we want ¥5bn exposure on the long leg:
- Long ¥5 billion of 10Y JGB
- Short ¥5bn ÷ 0.212 = ¥23.6 billion of 2Y JGB
Step 2: Verify Duration Neutrality
- DV01 of long position: ¥5bn × ¥9,200 = ¥46 million per bp
- DV01 of short position: ¥23.6bn × ¥1,950 = ¥46 million per bp
✓ Position is duration-neutral.
Step 3: Calculate P&L Scenarios
The P&L of a curve trade depends on the change in spread:
\[\text{P&L} = \text{DV01}_{spread} \times \Delta(\text{Spread in bp})\]For our steepener, $\text{DV01}_{spread}$ = ¥46 million.
Scenario A: Curve steepens by 10bp (spread moves from 60bp to 70bp)
- P&L = ¥46 million × 10 = +¥460 million profit
Scenario B: Curve flattens by 10bp (spread moves from 60bp to 50bp)
- P&L = ¥46 million × (-10) = -¥460 million loss
Scenario C: Parallel shift (both yields rise by 20bp)
- 2Y yield: 0.20% → 0.40%
- 10Y yield: 0.80% → 1.00%
- Spread unchanged at 60bp
- P&L ≈ ¥0 (duration-neutral protects us)
This example shows how curve trades isolate spread risk while hedging parallel shift risk.
Flattener Trade
A flattener is simply the opposite position—it profits when the curve flattens (spread narrows).
Using the same bonds as above, a 2s10s flattener would:
- Sell (go short) the 10Y JGB: Short ¥5 billion
- Buy (go long) the 2Y JGB: Long ¥23.6 billion
This position profits if:
- Long-term yields fall more than short-term yields, or
- Short-term yields rise more than long-term yields
When flatteners work:
- BOJ begins tightening policy (short rates rise faster)
- Flight to quality drives long-end yields down
- Term premium compression
Common Curve Spreads in JGB Markets
While 2s10s is the most liquid, traders also monitor:
| Spread | Use Case | Typical Range |
|---|---|---|
| 2s5s | Front-end policy expectations | 20-50bp |
| 2s10s | Most liquid, macro hedge | 40-80bp |
| 5s10s | Medium-term policy view | 20-40bp |
| 10s20s | Supply/demand dynamics | 20-50bp |
| 10s30s | Pension/insurance demand | 30-60bp |
| 20s30s | Ultra-long positioning | 10-25bp |
When Curve Trades Work Best
Curve trades are most effective in specific market environments:
1. Monetary Policy Transitions
Steepeners perform well when:
- BOJ signals the end of ultra-loose policy
- Market prices in future rate hikes (short end rises first, then long end)
- YCC (Yield Curve Control) is being phased out
Example: In March 2024, when BOJ ended negative rates, the 2s10s spread widened from 55bp to 75bp as the 2Y yield rose sharply while 10Y remained anchored.
Flatteners perform well when:
- BOJ begins actual tightening (short rates rise)
- Recession fears emerge (long rates fall on growth concerns)
- Term premium compresses
2. Term Premium Changes
The term premium is the extra yield investors demand for holding longer-maturity bonds. When this premium expands or contracts, curve spreads move:
- Rising term premium → Curve steepens
- Falling term premium → Curve flattens
BOJ quantitative easing historically compressed term premiums, flattening the curve.
3. Supply/Demand Imbalances
Specific maturity sectors can be affected by:
- Heavy issuance at one tenor (steepens spread if at long end)
- Strong institutional demand (pension funds buying 20Y+ flattens 10s20s)
- BOJ purchases concentrated at specific maturities
Risks in Curve Trades
While duration-neutral, curve trades still face several risks:
1. Carry Drag
If the curve is steep and you’re running a flattener, you’re:
- Long the lower-yielding bond (2Y at 0.20%)
- Short the higher-yielding bond (10Y at 0.80%)
You pay away 60bp per year in negative carry. The curve must flatten enough to overcome this drag.
Conversely, a steepener earns positive carry when the curve is steep.
2. Non-Parallel Shifts
Duration-neutral construction assumes parallel shifts. But yields can move in complex ways:
- “Twist” (one end moves, other doesn’t)
- “Butterfly” (middle moves differently than wings)
These can cause P&L even in a duration-neutral position.
3. Execution Risk
Curve trades involve two simultaneous transactions. Poor execution can result in:
- Slippage: Bid-offer spreads widen your entry cost
- Leg risk: One leg executes, market moves before second leg completes
- Liquidity: Off-the-run bonds may have wider spreads
4. Financing Cost Volatility
If repo rates spike (especially for the short leg), financing costs can erode expected returns.
5. BOJ Intervention
The Bank of Japan’s bond purchases can distort normal curve relationships:
- YCC historically pinned the 10Y yield, preventing normal curve dynamics
- Unlimited fixed-rate operations at specific tenors create artificial anchors
- Post-YCC adjustment (2024-2025) restored more normal curve behavior
Practical Implementation Considerations
When executing curve trades:
- Use liquid issues: On-the-run bonds have tighter bid-offer spreads
- Monitor roll dates: Position may need adjustment at bond auctions
- Track carry carefully: Know your break-even curve movement
- Consider futures: JGB futures can be used for one leg (especially 10Y)
- Scale appropriately: Larger positions face execution challenges
Historical Example: 2024 YCC Exit
In March 2024, the BOJ ended its negative interest rate policy and began phasing out YCC. This created significant curve trading opportunities:
Before (February 2024):
- 2Y yield: -0.05%
- 10Y yield: 0.70%
- 2s10s spread: 75bp
After (June 2024):
- 2Y yield: 0.25%
- 10Y yield: 1.00%
- 2s10s spread: 75bp (unchanged!)
Despite the parallel shift upward, the spread remained stable. However, within this period, the 2s10s traded between 60bp and 90bp, creating profitable curve trading opportunities.
Winning trade: Steepener in April when spread compressed to 60bp, unwound in May at 85bp = 25bp profit.
Relationship to Other Strategies
Curve trades connect to other JGB strategies:
- Carry trades (4.2): Steepeners naturally earn positive carry in steep curve environments
- Butterfly trades (4.4): More sophisticated three-legged curve positioning
- Basis trades (4.5): Futures basis varies by maturity, creating curve opportunities
Understanding curve dynamics is fundamental to all JGB trading.