The difference between the yield on the 10-year notes and 30-year bonds is known as the NOB spread (notes over bonds). The NOB spread is used by many to gauge economic expectations and also the shape of the yield curve. Pete Mulmat from the CME discusses strategies using /ZN and /ZB to trade yield curve assumptions.

Tony: Thomas, we're back my friend. Closing the gap futures edition.
Tom: This is one of our favorite segments Bat, between the security side and the future side, this has become a tastylive original and it's been great. Pete how are you?
Pete: I'm great Tom, how are you? Tony how you doing? Happy birthday.
Tony: Thanks again, appreciate it. Good to have you back.
Pete: Thanks.
Tom: All right, I'm sick of this birthday stuff, it's already over the top. You made your case, you saw the whole production.
Pete: I did, it was fantastic.
Tom: You have videos, t-shirts, you done?
Tony: Market's starting to move our way, I mean almost.
Tom: Now you're going to take credit for the market.
Tony: Of course.
Tom: Linda can you throw up the Atlanta show for a quick second, the reason I want to do this is that … I will be in Atlanta tomorrow and doing key note speech and also Pete will be there.
Pete: I will be.
Tom: Talking earlier in the day, I don't know what time. Do you know what time?
Pete: Yeah, around 1:00, I'm talking a little bit to highlight CB products-
Tom: Great.
Pete: See what opportunities we can find there, really excited.
Tom: If you want to come by I speak at 2, Pete speaks at 1 and it should be fun. I mean it's going to be fun for sure and I just wanted to give a little heads up, because it's not going to be just me tomorrow. I can't wait to see everybody and it's not too late, if you're in Atlanta or the Atlanta area and you want to come by we'd love to-
Tony: Completely free.
Tom: Yeah, and the other nice thing is that Pete hangs around, I hang around, you can ask any questions, you know and it's great to have a futures expert there. He's the director of education at the [Murk 00:01:28] and you just talk nonstop at people.
Pete: Yeah, it's a great experience, people come out that have got fantastic questions, good interest and it's a wonderful program. [JayJay 00:01:38] does a great job and you guys are [crosstalk 00:00:00].
Tom: It's nice because there's no sales okay, it's legit hardcore just trading and investing information and you can ask anything. Nothing is off limits, okay it's live, nothing's off limits. Pete I'll see you there tomorrow, cant wait.
Pete: Yeah, look forward to it.
Tony: Don't be surprised if more people come up to you now, because they're going to feel like they know you so…
Tom: He's a super star now.
Pete: Yeah.
Tom: All right let's get back, ready for today?
Pete: I sure am.
Tom: We've got a great segment, thank-you so much for your help with our research team and you guys have been working together great. Today we're going to talk about something called the NOB spread, which I just put on this morning.
Pete: That's right.
Tom: Haven't traded it in a while, but I used to love the spread. What is the NOB spread?
Pete: It's a great spread, it's something we traded for years. NOB stands for notes over bonds, so it's basically looking at the spread between a 10 year treasury and a 30 year treasury. We're looking at basically the difference in the yield curve, the yield curve is basically a graph or representation of yields for different maturities for instruments. Everything for 3 months out to … we have an ultra bond that goes out 40 years, so that slope of that yield curve, in other words what rates are for each of those instruments, gives us not only a trading opportunity, but an indication of where interest rates may be heading and also an indication of economic activity.
Tom: Were you a market maker in this particular product ever? Or no?
Pete: You know what? We actually did a lot of electronic arbitrage in this-
Tom: Oh, okay.
Pete: So we would actually be trading 10 to 30 years.
Tom: Pete, when you say you can, it helps to give you … I would think this is great engagement for futures and for debt instruments, but how does it give you any kind of a tell as to … Maybe just like future interest rates or bond prices or how does that work?
Pete: Right and you know that's a great question, because really the curve and especially the long end of the curve is very sensitive to things like inflation, to economic activity. If we see the curve move, in other words if 30 years become … and one of the things we're going to talk about today which is a little different with what we talk about interest rate futures, is the pricing convention. All of us are used to talking about interest in terms of yield, when we talk about the instruments we're talking about today, the 10 year, the 30 year bond futures. They're quoted as price, when yields go up-
Tom: It's a little inverse.
Pete: When prices go up it's inverse, right. What we want to be able to do is look at this relationship, and what we can see from it sometimes is in times of … when we think the economy is slowing or we may see a [flight 00:04:20] to quality from some sort of geopolitical effect.
Tom: Right.
Pete: We can see money flow into the long end of the curve, we can see people buying 30 years.
Tom: Right.
Pete: We'll see that yield curve, or that relationship the 30's and the 10's, or the 30's and the 2's shrink. So oftentimes we're looking at that in terms of as economic activity increases we can see-
Tom: Would you say this is the most actively traded kind of pair or combination of instruments?
Pete: The NOB spread is a classic that's been traded for a long time. It's still a very liquid, very deep traded market, as the treasury has shortened maturities over the last 5 years-
Tom: Right.
Pete: Of what they issue, actually the 2 10's curve is also a very active traded curve. Again with rates at 0 at the front end…
Tom: What do you call the 2 10?
Pete: The 2 10, that's it. There's nothing quite so clever as the NOB spread.
Tom: All right, I got it.
Pete: For the ultra bond which is our long bond, against the 30 year note it's called the BOB spread.
Tom: Got it.
Pete: We've got the NOB, BOB and 2 10's.
Tom: The difference between the yields on the 10 year notes and the 30 year bonds Tony, is known as the NOB spread. It's the first spread I ever learnt about when it came to trading bonds, and having traders on the floor of the … at the time it was the Chicago board of trade. The spread is currently about 82 basis points, which is the difference between the 10 year yield and the 30 year yield. So it's 82 basis points, 2.54% to 3.36%, a level that is historically low. Traders may want to keep an eye on the NOB spread as a signal of where interest rates might be headed. That's what you just talked about, the NOB spread helps to gauge the current shape of the yield curve. The yield curve simply plots the yields on the bonds with varying maturities, typically 3 months to 30 years out. Now again, I think you said this really well Pete, because in fairness most traders are not that focused. You have to remember what the mentality is of an investor slash trader using these products, the mentality is they want to make money, they're not economists, we don't get paid for guessing the long term interest rate curve. That's not how you make a … it may effect the things you do in life, like maybe a house purchase, maybe a refinancing a mortgage, whatever it is. But for the most part we look at the NOB spread, because you said this perfectly about price, because it's all about … we're trying to gauge opportunity. The NOB spread by definition would be lower risk engagement, because you are able to extend duration because of the spread, and reduce risk because of the off set.
Pete: Absolutely and that's what's great is, ideally when you trade these spreads you could trade them on a 1 to 1 basis, but we're going to talk a little bit about actually weighting the spread appropriately. So you are really just exposed to movement within the yield curve, not parallel shifts in the interest rates, in other words-
Tony: If you were doing a 1 to 1 it would be a lot more risk.
Pete: If you did a 1 to 1 spread you would have actually out right interest rate exposure, here we're looking at a different trade.
Tom: Right.
Pete: We're not playing on the direction of rates, we're playing on the direction of the difference in instruments.
Tom: You're betting on the basis.
Pete: Right.
Tom: Our viewers understand that and they're just starting to learn more and more, but it's betting on the basis. Now you can … to take what you just said one step further, you can actually tweak the ratio, so that instead of 2 to 1, you could do 1 to 1, instead of 2 to 1, you could do 3 to 1, that way it allows you to be a little bit longer, a little bit shorter to tweak-
Tony: 3 to 2…
Tom: Which is one of the most coolest things about trading, especially electronically now is that you can do that as an individual investor, and it's just hey you know what? I just tweaked my delta a little bit, that's all.
Tony: So 1 to 1 would be, like you said an interest rate play, but that's more of a directional play on interest rates.
Pete: It's more of a directional play on interest rates because the bond, and we'll talk a little bit about this, the dollar value or basis point is greater on a longer term maturity instrument, like a 30 year.
Tony: 2 to 1 is more strategic.
Pete: 2 to 1 would actually equalize that dollar value, what you want to be able to do is compute for one basis move in interest rates. How does that contrast move? And you want to equalize that, so if the 10 years move one point, the 30 years move 1 point, that's a parallel shift in rates. We want that to neither give us a profit or loss if we're constructing a yield curve.
Tom: Yeah.
Pete: By figuring out the dollar value of a basis point, which there's many tools out there, CME group has a great duration tool they call it, that will compute that for you. The current ratio happens to be approximate, very close to 2 to 1 so you want [crosstalk 00:00:00]-
Tom: We'll get into that in one second.
Pete: 2 notes to a bond. Here we have the chart of both the 30 year bond price on the right and the 10 year note price on the left, and we can start to see here … and below is the spread relationship, we've waited that spread relationship.
Tom: Yeah.
Pete: It's very interesting, and we've seen it since the [fed 00:09:18] meetings minutes last Tuesday, that the feeling is that they're going to be very guarded with what they do with rates. So we've seen some of that selling of the curve, speculation that the long end would rise quicker come out of the market, and as we see that, we see the curve do what we call flatten.
The 30 years have rallied more than the 10 years and the rate curve, the difference between the two has flattened.
Tom: Yeah, this is amazing conversation I'll tell you why, because it is very hard to explain the NOB spread to individual investors and why you may do it. But looking at this little graph right here, you can see that as a contrarian.
First I'll go to the bottom piece, when you say in there that the curve is flattening but you can also see based on price, if you were to say to any one of our 50,000 viewers right now, hey which would you rather do right here? Sell it down here, or buy it down here as a contrarian, you're going to think you're going to buy it. That's why I bought it today.
Pete: Right.
Tom: If you look up above, you're going to see this relationship, and how often it crosses over back and forth. There's no specific reversion to the mean, to be fair. But when you look at this, you'd be hard pressed going back to 2011 to suggest that it hasn't had reversion to the mean, and if you look at the red and the blue, that's about as wide as we've seen it.
So you've got ridiculously low total basis price, and you've got a really clear picture there, and you do see over time. Yeah we had that one year period where there wasn't much, where it didn't go back and cross over, but there tends to be long term reversions to the mean.
Pete: There absolutely is and you know as we see, it will be very interesting because we're coming out of a quantitative easing environment, a very different set of fed tools. So how the curve reacts you can-
Tom: Right.
Pete: Traditionally the curve would react by, as the fed raise short term rates, we'd see the curve actually contract. In other words short end would raise, rates would rise faster than the long end. With the questions about inflation now coming in, basically the yield curve represents current fed policy, expected fed policy and inflation expectations.
So those are the 3 dynamics that tend to drive the yield curve, so as we see one of those 3 variables change, whether it be expected or actual fed policy, or we're starting to see a change in inflation. Those are guides that will let us find opportunity in the yield curve trade.
Tom: You know Tony, you'll hear a lot of times when you're reading something in like the Wall Street Journal, or you're watching something on business news. You'll sit there and people will say "Well the yield curve is doing this, the yield curve is flat". For 99.99% of individual investors, self directed investors, which is the audience we reach, they would have no idea.
Okay so what am I supposed to do, the yield curve is flattening.
Pete: Right.
Tom: You know, what's my mom supposed to do? You know what I'm saying? It's like okay, I don't know. But the beautiful thing about this conversation is, now you know what to do.
Tony: That's correct.
Tom: Now you buy the NOB spread. So the shape of the yield curve gives some investors a sense of economic expectations in general. Strong economies, steepening yield curves with longer maturities, yields increase more than the shorter maturity yields. Weak economies, flattening of the yield curve, and by the way all this is archived so you can go to it forever into perpetuity.
I believe you guys also archive this on your site-
Pete: We do.
Tom: So it's great. Longer maturity yields decrease more than shorter maturity yields, so now all this starts to make sense and it's investible.
Possible curve trades are flattener and steepener, strategies of getting long or short the near term, the front leg, and the long term, the back leg in bonds. So Pete explain this to us, because we don't use … typically coming from a different background-
Pete: Right.
Tom: We don't use the terms flattener or steepener.
Pete: Right and really let's go through the language a little bit. Flattener would mean, as we said if we think about that yield curve as a line.
Tom: Right. Okay.
Pete: An upward sloping line right now, so rates in the future, rates for longer data instruments have a higher return than shorter data instruments. A flattener would suppose that rates would equalize, so in other words either the long end would come down or the short end would go up.
Now there could be a bull flattener or a bear flattener, now a bull flattener would be where that relationship came together, but in a rising price lowering rate environment.
Tom: Right.
Pete: Remember we're always talking reciprocal, in terms of a steepener, a steepener would be where the spread would widen out, so in other words the long end would move away from the short end. The difference would increase, and again we can have a bull steepener or a bear steepener, same thing there too depending on the overall direction of rates.
When we talk about this spread so we have a common language of convention, we always want to talk about what we're doing in the spread is the front leg or the … when I say the front leg I mean the short duration leg.
So if we were doing in instance the NOB spread the 10 year leg, whatever we're doing in that, we're buying the spread, we're buying the 10 year. If we're selling the spread, we're selling the 10 year and buying the 30.
Tom: So I bought 10 years today, so I bought the NOB spread.
Pete: You bought the NOB spread.
Tom: Just so everybody knows, first of all we're learning stuff that we didn't know today and-
Tony: Of course, especially the terminology which is something that we throw out there in our own field all the time.
Tom: Just to give you also some background, some tastylivers like TP, this is where he originally started to trade, was trading the NOB spread, the 10 year, the 30 year, the 5 year you know and that was his first job in the business. So a lot of this stuff comes full circle.
The risk measure used for curve trades is the dollar value of a basis point and basically the delta of the bond. The back leg will always have a greater delta than the front leg, so the hedge ratio must be calculated to result in a delta value, that's what that stands for right?
Pete: Right.
Tom: Delta value-
Pete: Well actually DV stands for dollar value.
Tom: Dollar value, okay. Dollar value versus the neutral position. This is essentially the same as creating a delta neutral position with options. I think we get that, that's cool, and this is calculating a spread ratio for the 10, 30 year steepener. I love this.
ZN which is the 10 year note, and now what you've done is you've created the … you're showing everybody the model to a dollar value of 70.6, and the 30 year which is 139.6, which is why you're doing this spread 2 to 1.
Pete: Right, absolutely. As maturity extends, duration and basically the volatility of the bond, because it's a longer term to it, it's a greater volatility. What we try to do is again, we want to assign for each basis point of interest rate move, we want the spread, both instruments to have the same weightings.
To do that we figure out and it's very readily … the CME group has the-
Tom: Right.
Pete: Dollar value of a base point updated continuously, so you can always look at that. The treasury department has the same thing on their site, and what we want to do is weight this trade so if rates both move in parallel we don't see any movement on our spread. We want to take advantage of movements in the spread, so it's a great way-
Tom: What can people expect on a daily basis? Like what would be a normal … the expected move of the basis of the spread.
Pete: Right.
Tom: So I put it on this morning, and for whatever price I did it for, if I'm correct which we know that's the bet, are we talking about a spread that moves 5 ticks a day? A tick being $31.
Pete: Right.
Tom: Are we talking about spread that moves-
Tony: [crosstalk 00:16:48] moves 25.
Tom: Yeah, are we talking about a spread that moves 10 ticks a day? I'm just curious, for risk purposes.
Pete: You know, we can see movements of half a full point, so we can see 15, 20-
Tom: Right.
Pete: 20 ticks of movement in that spread, depending on what's going on in the [smoothes 00:17:08], what's come out in terms of releases as to unemployment and again as expectations change, we'll see people modify their positioning around this curve.
I mean so we can see good opportunity and good movement around this and one of the things that is great is, this trade let's you construct an opportunity that's separate from a movement right. So as we're-
Tom: Absolutely, absolutely.
Pete: We're stuck still in a relatively low rate environment, without a lot of volatility, so this is a great way to find another venue, another I hate to use the word [Aye-Oh 00:17:41] because it sounds … but look through another lens to find trading opportunities.
Tom: We call it engagement, we use the term, it's a broad based term we center around this concept of market awareness. If you're going to be a really good trader slash investor you have to have kind of a global sense of awareness now. So when somebody talks about interest rates, you understand what they mean.
Pete: Right.
Tom: You understand what they mean as it relates to you. You know, how do I make money off interest rates, we all know that in some point in the future interest rates are going higher. So if everybody knows that then how do I make money off that? And that's what this is, it's another way to engage yourself and play the curve.
I actually like trading because I'm not, you know it's just another way to trade bonds and give yourself enough duration to be right, it reduces risk.
Pete: That's absolutely spot on in terms of looking at this, it's that you can really by constructing these spreads, you can weather some of the noise that sits within these moves.
Tom: Of course.
Pete: And still look for the opportunity.
Tom: Weather the bond noise too.
Pete: Right.
Tom: So you're talking about yell and talk at a luncheon meeting today, and you have a bond position on you're like oh great I don't want to deal with this. You know, I don't want to deal with the point of risk higher or lower.
Pete: Right.
Tom: But if you have this spread on you're dealing with a couple of ticks, that's the difference. So traders can take advantage of the currently flat 10 year, 30 year curve using options on futures as well. Remember the spread ratio is 2 bonds to a note, we put this up here because the first time you look at bond options you're going to be a little bit … haven't been decimalized.
Pete: Right.
Tom: It's not rocket science, but it's not the same. It's the one product still that kind of, it's an outlier in the sense it still uses fractions.
Pete: Right.
Tom: The reason we put this up here is because you can get using different delta equivalents, you can get much smaller than 2 notes and 1 bond. You can get to a fraction of one bond, and a fraction of 2 notes using options.
Pete: Right.
Tom: Again I'm going to caution you that if you've never traded bond or note options before, it takes a little bit of getting used to going back into the world of fractions, you know.
Pete: Here in this set up we took a look at both at the money calls for the 2 instruments, and that pricing convention a 1 dash 37. Now they're quoted in 64ths.
Tom: Right.
Pete: It's really 64 plus 37 times the tick value, that's where your coming up with that dollar value of the premium, so it's-
Tom: If it's the first time you're seeing it, it's a little confusing.
Pete: Yeah, it's definitely a different … you know it goes back to the way that notes and bonds are quoted on the future side they're quoted in 30 seconds, but certainly people knew to that quoting convention, it is a little unique and…
Tom: The two reasons for using options in this case, and we've got to wrap up here because we're going to run long Tony, but the two reason for using options. The first one is to create data, which in again is-
Tony: It's another strategic component to it.
Tom: Right now bond volatility is very middle of the road, it's a little middle of the road.
Tony: Yeah, middle of the road relative.
Tom: So it's not that rich.
Tony: It's not low.
Tom: No it's not low, but its not … it's richer than SMP volatility but it's not like where you say oh I'd rather sell options.
Tony: Sure.
Tom: One is to create data, the other is to get smaller. What I mean by that is because you can use the delta value whenever you want, so your delta value of 50 is half the size, the delta value of 25 is a quarter of the size and that's the reason you do that.
If a trader expected a longer term yields to fall faster than short term yields, a flattener spread could be used. Remember, the ratio is always 2 to 1 notes over bonds, but then you can adjust accordingly for whatever you're market opinion is.
Tony: Of course and I didn't get a chance to put it up there or see the break time but let's do it right now. The way that we did it this morning was buying 2 notes, the way the graph it would be this is what you're buying 2 notes. 2 with the little multiply sign divided by ZN minus forward slash ZB.
Tom: You can see it's the same one we showed earlier, the same one but you can see how kind of over … listen we're playing the contrarian game.
Pete: Right.
Tom: Pete that was awesome man, that was just another great … you're 3 for 3.
Pete: Well you guys make it awfully easy I really appreciate it.
Tom: We'll keep this streak alive but this is great content and people should appreciate you in a short session how much you just got in there it's awesome. Thank-you so much.
Pete: Tom you're welcome, Tony thanks so much.
Tony: Thanks again.
Tom: We'll see you tomorrow.
Pete: Okay.
Tony: We've got the opening bell in about 90 seconds. This is tastylive live.