The Curve

Path dependency in action

In the interest rate report, I noted that there is a very high degree of path dependency in the curve (link):

Let me provide a tangible example of this. Notice this marginal repricing in the 2 year caused the curve to flatten significantly over the past couple of weeks:

For example:

Notice that while the short end is consolidating, these curves are now mean reverting back up:

The main idea here is that every time a hike or cut begins to get priced in the short end of the curve, it begins to impact the long end. The long end is always anticipating what will occur as a result. This is path dependency.

If you are trying to understand these dynamics better, check out the interest rate primer:

These curves can actively be traded via the bond or SOFR futures. When you are trading curves, there are many complex expressions you can have but here is the main idea: Positive optionality to multiple outcomes. Many times an outright long or short in bonds can only pay in a single outcome whereas a steepening or flattening of the curve can occur in multiple outcomes.

When you are trying to reduce your risk and increase your reward, you want to be right in multiple outcomes. See my week ahead notes here for the trades I am running in connection with this steepening of the curve:

More on this topic later