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This excellent analysis of the famous Robertson Curve Steepener trade comes from our friend Jay at MarketFolly:

Yesterday on CNBC, the wizard of Wall Street and hedge fund legend Julian Robertson was on what seems to be his once-a-year CNBC appearance. The Tiger Management founder talked about inflation expectations and a theoretical scenario if China and Japan stopped purchasing US bonds. He also talked about some of his investment plays which we were interested to hear about. It’s tough to track him since he generally likes to keep out of public’s eye, but we have a prime opportunity to hear his investment ideas through our discount to the Value Investing Congress (discount code: N09MF3). Julian will join prominent hedge fund managers David Einhorn of Greenlight Capital, Bill Ackman of Pershing Square, Joel Greenblatt of Gotham Capital and many more to present actionable investment ideas at the 2-day event. If you want to learn from some of the best in hedge fund land like Julian Robertson, this event is a must-attend.

Julian’s Updated Position

As we covered a long while ago, Julian Robertson’s favorite play at the time was essentially an inflationary bet as he liked curve steepeners. Since then, he says he has refined his play and has turned to the curve cap. He says, “The curve steepener was a measurement of the differential between short and long term rates and we figured short term rates would go down and long term rates would go up. We didn’t do well on the long term part, but the short term part worked out so well that actually we made a little money on the trade. Short term rates are nothing, so they can’t really go below nothing. We’ve shifted the curve steepeners, which are basically long-term puts on long-term bonds… highly leveraged and they’re like puts in that you know what your risk is, it’s measured by what you paid for the put. I think (long term rates) can go to 15, 20 percent.” He then also went on to focus on the economy and the situation we are presently in by saying, “I really do think the recession is at least temporarily over. But we haven’t addressed so many of our problems and we are borrowing so much money that we can’t possibly pay it back, unless the Chinese and Japanese buy our bonds.”

Curve Steepeners Versus Curve Caps

Robertson had been in various forms of a curve steepener for a few years now and it appears that he keeps adjusting and tweaking the play as the market and economy shifts. We’ve heard about curve steepeners, steepener swaps, and now curve caps as well. We thought it would be prudent to quickly touch on these instruments for those less familiar with them as they are in fact highly leveraged institutional play. The closest thing we can compare them to is put options on long-term interest rates.

Let’s start with the main focus of the curve steepener. Taken from eFinancialNews, “Steepeners are a type of interest rate swap, where one party agrees to pay the other a fixed rate in exchange for a floating rate, which is derived from the difference between long and short term rates. Many of these products also use high leverage, where the difference between the two rates is multiplied by up to 50 times to produce a higher return.” This seemed to have previously been the most commonly used play amongst hedge funds. However, as Robertson noted in his interview, this vehicle is less desirable now that short-term rates are at zero and can’t really go below zero. As the market shifts, so does Robertson.

Seeing how he doesn’t want to play the differential between the rates anymore, he has moved on to CMS rate caps, or curve caps. In an interview with Value Investing Insight back in their May/June 2009 edition, Julian Robertson says, “The insurance policy I would buy is called a CMS [Constant Maturity Swap] Rate Cap, which is the equivalent of buying puts on long-term Treasuries. If inflation happens the way it could, long-term Treasuries are just going to explode. Less than 30 years ago, long-term interest rates got to 20%. I can envision that seeming like a very low interest rate compared to what might occur in the future.” As he says himself, the closest thing you can equate this play to is long-dated puts on long-term treasuries. However, the curve caps he is in are obviously more of an institutional play and are highly leveraged. The curve cap tries to capture the move in long-term rates whereas the steepener tries to capture a differential between short-term and long-term rates. For a more in-depth look at constant maturity swaps (CMS) we recommend reading the embedded document below from Eric Benhamou, a former Senior Quantitative Analyst for Goldman Sachs.