Fundamentals and Interest Rate Futures

Fundamentals and Interest Rate Futures

When it comes to trading Interest Rate futures, traders have a variety of products to choose from. Short-term products, like Eurodollar and Fed Fund futures, and extending along the yield curve to longer maturity products like 5-year and 10-year Treasury Notes as well as 30-year Treasury Bonds.

Traders looking to analyze the fundamentals of interest rate futures may review a variety of economic and market information. Some factors that influence pricing of Treasury futures include the level and slope of the yield curve, FOMC interest rate decisions, levels and frequency of U.S. Treasury debt issuance, demand for government bonds, and the overall health of the economy.

Yield Curve

The yield curve is a representation of the yield of securities along the various maturity points of the U.S. Treasury curve. For example, the U.S. Treasury regularly auctions securities with maturities of 2 years, 3 years, 5 years, 7 years, 10 years and 30 years. These are known as “on-the-run” securities and their yields are frequently quoted when referring to U.S. interest rates.

Traders will analyze the level and slope of the yield curve as one point of reference to future interest rates. Sometimes the yield curve will move in a parallel fashion with the yields of short- or long-term securities moving in tandem (parallel move). Sometimes interest rate changes affect one portion of the curve more than the other, causing the curve to steepen or flatten. Analysts will study the yield curve and build models on how they think yields will change for the maturity they are trading.

For example, someone trading the 2-year Treasury Note may see a larger price change in reaction to an FOMC rate increase than someone trading the 30-year Treasury Bond contract. In this case, the yield curve will shift because of greater price on the shorter-dated maturities versus the longer-dated maturities.

Federal Open Market Committee (FOMC) Decisions

FOMC interest rate decisions can have an important effect on the price of interest rate futures. The FOMC influences interest rates by increasing or decreasing the target overnight interest rate (or the effective fed funds rate). The overnight rate is the amount banks are charged to borrow or lend excess funds overnight. This rate is included in factors that influence what banks charge their customers to borrow funds.

If the expectation of an FOMC decision is an increase in the overnight lending rate, then interest rate futures may see a decrease in price. If the expectation is to lower overnight lending rates, then interest rate futures may see an increase in price.

Traders will want to keep an eye on the eight annual interest rate announcements from the FOMC (available on the FOMC website) and observe how the market reacts before and after the rate decisions are released. The rate decisions come with detailed explanations and projections from the FOMC. The wording of these releases is highly scrutinized by analysts and traders, and even small comments may have a large impact on the market.

U.S. Treasury Debt Issuance

As the U.S. Treasury issues debt in the form of notes and bonds, they increase the amount of securities available in the system and increase the amount of the debt owed by the U.S. government. This can put upward pressure on interest rates.

One result of the great financial crisis of 2008 was the U.S. central bank, known as the Federal Reserve, bought large amounts of U.S. Treasuries and other debt instruments. Due to the size of this activity, it had the desired effect of reducing interest rates.

U.S. Treasury interest rates are also impacted by global demand. Nearly 50% of all U.S. Treasury debt is held outside the United States. These non-U.S. participants can have a big impact on the Treasury debt pricing.

Overall Economic Health

Economic indicators that reflect the health of the U.S. economy have a big influence on the price of the U.S. Treasury market.

Economic indicators that influence the slope and level of the yield curve include inflation, growth, employment, and debt as a proportion of GDP.

Overall, the health of the economy is a primary influence on interest rates. When there is rapid growth with inflation, interest rates tend to rise and curve tends to steepen. In periods of slow growth and low inflation, rates tend to fall.

Summary

The U.S. interest rate market is influenced by the health of the U.S. economy and the issuance of U.S. Treasury. Risk managers and traders tasked with analyzing these markets should pay close attention to these factors.

The interaction between the economy and interest rates is complex. Traders looking at interest rate futures have a variety of fundamental inputs that can help them formulate opinions on price.

If you have questions send us a message or schedule an online review.

Regards,
Peter Knight Advisor

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