What Is a Curve Steepener in Government Bonds?
Government bonds (also known as treasuries) pay different rates of return depending on the number of years to maturity. In general, the more years to maturity, the higher the rate, although the opposite can infrequently occur. The interest rates plotted on a graph is the yield curve (see Resources). If you believe that this yield curve will get "steeper" such that long-term interest rates will be higher relative to short-term interest rates, a curve steepener trade can be profitable.
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Rates Change over Time
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Long-term interest rates are higher than short-term rates because of interest rate risk. This means that interest rates might change, and if they increase, the value of a bond purchased today will decrease. To overcome interest rate risk, long-term bonds must pay a higher rate to induce investors to buy them.
Long-term Rates May Change Relative to Short-term Rates
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Many forces can steepen the rate curve and make long-term interest rates relatively higher than short-term interest rates. The Federal Reserve itself can set the short-term interest rate, so lowering the rate steepens the yield curve. If investors expect inflation to rise in the future, the long-term rates will increase. In general, a recession steepens the demand curve (and a period of expansion flattens it).
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The Curve Steepener Trade
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If you believe one of the above events will occur, a curve steepener trade is one way to profit from the yield curve steepening. Basically, you buy short-term treasuries and sell long-term treasuries. This may sound counterintuitive because you are betting that the long-term treasuries will pay a higher interest rate in the future relative to short-term treasuries. However, when interest rates rise, the resale value of the bond decreases and visa versa.
Derivatives
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The changes in interest rates can be very small, and are usually measured in .01 percent increments. For this reason, to make money on interest rate changes, you will need to buy a lot of government bonds, which is usually only possible for investors by using derivatives. These financial instruments are riskier, but they don't require as much capital as simply buying and selling bonds.
Liquidity
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Government bonds are traded worldwide and are considered the world currency by some economists. For this reason, it is an extremely liquid market. This means that no matter how many bonds you are buying or selling, it is unlikely that you will affect the price of bonds with your trades.
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