Bond Bear Blues

Relative Value Carnage

Figure: 2/5/10 Treasury Butterfly

I saw discussions of the 2-/5-/10-year Treasury butterfly. Using the Fed H.15, the above shows the 50:50 butterfly spread. Although the one-day move was violent, this is not exactly unprecedented when looking at this time series (and if we go further back in time, the butterfly can get choppier, but the question is whether that is an artifact of the fitting methodology).

I do not want to dwell on what the butterfly represents, but one overly simplistic view is that the spread is an absolute measure of richness/cheapness (to be clear, that's not correct, but work with me anyways). Using that simplistic theory, the 5-year was "expensive" versus the 2- and 10-year points on the curve, and then it got a lot less expensive very quickly.

No matter how pedantic one wants to be about the definition of rich/cheap, the reality is that the spread snapped towards the 0 level, which is consistently crossed. This is different than the spread snapping towards extreme levels, which is the usual signal that something blew up in relative value territory.

The butterfly spread has no economic significance in itself, but it is important for rates trading. It is a way of making a relative value position without significant directional exposure to either the level of rates ("duration") or the slope of the curve. Since butterfly spread movements are small, you need to apply leverage to the position to get any returns. As such, one could imagine that some levered player did blow up somewhere.

However, there is no credit risk or even inflation risk involved. Real fixed income investors can lean into butterfly movements solely by overweight/underweight positions -- no leverage needed. So the butterfly spread cannot run off to far without being smacked back into place. Maybe there are problems in the vol world, but I do not have the data to comment on that.

Convexity Hedging, "We're Doomed"

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Disclaimer: This article contains general discussions of economic and financial market trends for a general audience. These are not investment recommendations tailored to the particular needs of an ...

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