T-bond/T-note Spread: Time to Get Short?

Dead Cat Bounce

The US treasury market spent the last half of 2017 going straight down.  An improving economy, a December rate hike with the prospect of more to come, the post-election stock market explosion, and ideas that a Trump victory will make things even better have caused traders and investors to abandon bonds as quick as possible.

For the last month, however, the treasury market has bounced back on ideas that the meltdown has been overdone.  From a technical standpoint, this looks like nothing more than a “dead cat bounce” or a correction in an overall downtrend.  If so, this is a short sale opportunity.

Yield Curve Spread

As readers know, the IMC blog is all about trading the intermarket spreads.  Treasuries are no exception.  Therefore, our interest lies in identifying trade opportunities in the T-bond/T-note spread.  Old time traders may remember this one as the NOB spread (Notes Over Bonds).

One thing you may notice on the blog is that we often trade the T-bond/T-note spread at a ratio of 1:1.  Many yield curve traders do this spread at a ratio of 3:1 where they have three ten-year note contracts for every one thirty-year bond contract.  This is done to account for the higher volatility on the longer end of the yield curve and smooth out some of the volatility.

The reason I have always done a ratio of 1:1 is to get positioned for a more directional bet.  This allows me to take a smaller spread position that I would have to do with a 3:1 ratio to match my risk appetite.  It also means I pay less in commissions.

There’s no right or wrong here.  It’s a choice to make based on your personal preference.

The Last Few Weeks

The nearest-futures T-bond/T-note spread rallied nearly three full points off the December multi-month low.  This bounce is a little bigger than the two and a quarter point bounce off the September low.

So either this is an ‘overbalancing of price’ that marks a trend change…or it’s the perfect place for the decline to quickly resume and take the T-bond/T-note spread to new lows.

I’m sure someone reading this is saying, “Gee, smart guy, that’s not much help.  You’re saying it could go either way then!”  Well, that’s just the first observation of the recent price action.  Let me put another layer of technical analysis on top of that to bring some more clarity.

Trend Parameters

Most market technicians are familiar with the 200-day Moving Average.  It’s probably one of the first things you learned about when you started charting.  The 200-day MA is a cornerstone metric used to determine the long-term market trend.

In late February of 2014, the nearest-futures T-bond/T-note spread made a sustained close above the 200-day MA for the first time in nine months.  This bullish trend change signal did its job well as it carried the spread higher for nearly two and a half years.

Who says that trend following is dead?!

Now, we do have to acknowledge that there was a brief period of choppiness in late 2015 when the spread dropped below the 200-day MA in the first part of November for a few days and recovered.  It then dipped back under the 200-day MA again for a few days at the December and recovered right after the new year began.  These were both false bearish trend change signals.  Other than that, though, the spread maintained itself above the 200-day MA.  So it still works a lot more often than not.

After topping at a record high last July, the spread pulled back, hit a trading range for several weeks, and then started to work lower again right after Labor Day.

On September 16th the T-bond/T-note spread came within spitting distance of that widely-watched 200-day MA.  Apparently, the significance was not lost on market participants because that’s where the big bounce happened that we talked about earlier.

The Game Changer

The bounce off the mid-September low faded as the third quarter drew to a close.  Then something very significant happened in the first week of October: the T-bond/T-note spread dropped to a new multi-month low and made a sustained close below the 200-day MA for the first time since the first week of 2016.

This was a major bearish trend change signal.


T-bond T-note spread (200-day MA) daily

Over the next two months, the T-bond/T-note spread dropped an additional nine full points.  That’s a big deal in Treasuries!  This spread is in a bear market, folks.

Zooming In

Take a look at how the spread has reacted to the 50-day Moving Average as well.  After peaking in early July and then hitting a trading range in August, the T-bond/T-note spread made a two-day below the 50-day MA for the first time in over three months.

In the first part of September, the 50-day MA also started to roll over.  This tipped the scales further in favor of the bears.


T-bond T-note spread (50-day MA) daily

Interestingly, the rally off the December low pushed the spread up enough to finally get a close back above the 50-day MA this week.  This is either an early warning that a bullish trend change is coming or it’s the maximum stretch point before the rubber band snaps back.

The spread is starting to sell off today.  A close under the 50-day MA today could indicate that technical resistance held and that the bounce is over.  Therefore, this provides a setup for a short sale.  We are willing to take it and see if this Friday the Thirteenth is our lucky day.


March T-bond T-note spread daily

Here’s one more for the road: On November 3rd the 50-day MA closed below the 200-day MA for the first time in nearly nine months.  This was a classic death cross signal.  Who wants to fade that?!


T-bond T-note spread (50-day and 200-day MA) daily

Trade Strategy:

T-bond/T-note Spread

The blog will make a hypothetical trade by shorting one March T-bond contract and simultaneously buying one March T-note contract if the spread closes below the 50-day Moving Average (currently at 27-01).  Initially, the spread will be liquidated on a two-consecutive day close 8/32nds (one-quarter of a point) above the 2017 high (currently at 28-00).