Zero Hedge has a great chart in a post that shows a bear flattener in action. It’s so good, I had to use it here:
That steep, carry trade inducing yield curve is not looking so steep now. You can see as the curve at the 3m data point come up rather violently in 7 weeks. It’s almost a 200bp move up.
But look at where the real whipsaw action is: it’s the intermediate part of the curve from the 1Y to the 10Y. Remember what I said about the law of large numbers and rate shocks? Yup, that’s it in action: front and center. Volatility in that part of the curve has seen an off the charts move upward. Anyone who stuck their toe in anywhere along that part of the curve has been left bloody, bruised, and broken. The portfolio managers are in much worse shape.
So let’s put that into our VaR black box and smoke it… because that kind of move in that period of time just isn’t something we’re supposed to see, right?
Oh yeah. And the last three years never happened, either…
But when I started talking about a bear flattening scenario here, I thought it would also make sense to look at how such a scenario can unfold and why it’s so dangerous. So I’m going to use a fictitious yield curve (it’s not that fictitious, it’s based on the Greek yield curve) and build a relatively simple $100,000 portfolio, where I borrow at the front end of the curve and lend at the back end. Simply put, it’s a ‘borrow short/lend long’ strategy. First, here’s the chart:
Now here’s the fictitious portfolio and some analysis I did:
The point was to illustrate what would happen if you had a maturity mismatched portfolio and a bear flattener occurred. Needless to say there’s some definite risk there with the funding piece of the portfolio in this situation.
Later on, I’ll see if I can’t define/develop a hedging strategy.