The yields on Treasury note futures, Eurodollar futures and U.S. T-bonds and notes are tightly connected through processes of hedging and arbitrage. It should come as little surprise, then, that the analysis of two of these can be used to forecast the third.
First, we need to establish some ground rules. Eurodollar futures quarterly rates may be averaged by computing geometric means of successive rates to form a yield curve that is separated from the Treasury yield curve by credit and convexity spreads. Nominal yields on T-note futures (10-year, five-year and two-year contracts whose nominal prices are listed by the Chicago Board of Trade, CBOT) may be estimated on hypothetical 6% coupon bonds, corresponding to the nominal prices listed by the CBOT.
It is important to point out that T-note futures contracts are not interest-bearing securities, and thus have no actual yield. This does not prevent the futures on T-notes from being used in arbitrage and hedging strategies, but it does mean that calculation of nominal prices and yields implied by T-note futures contracts must be viewed as hypothetical figures.
CURRENT SITUATION
“Three yields” (below) charts hypothetical yields based on nominal prices listed by the CBOT for 10-year T-note futures, yields shown by Bloomberg.com for 10-year U.S. Treasury securities and 10-year yields derived from Eurodollar futures. Although the timing of movements in the three series is similar, there are significant differences indicated by the spreads between the yields.]
The spread between T-note futures and Treasury yields through the period from mid September 2006 until the end of the year varied from 30 to 37 basis points. Yields on Eurodollar futures rose further, adding a credit spread based on the risk difference between U.S. Treasury securities and the private bank deposits on which Eurodollar futures are based. In “Three yields” we can compare the variations of the three different instruments.
“T-note/Eurodollar connection” (below) traces the differences between nominal T-note futures yields and Treasury yields. This series of differences may be compared with the price movements of the September 2008 Eurodollar futures contract shown on “Eurodollar futures” (below). Comparing the two charts shows the differences could be possible leading indicators of Eurodollar price changes.
The total range shown for T-note futures yields less Treasury yields is just seven basis points compared with the span of 65 basis points for the Eurodollar futures price; however, the differences are able to reflect the movements of futures prices.
ONE-WAY EFFECT
Because of their function in hedging and the need to match the current movements of interest rates and yields, neither Eurodollar futures nor T-note futures are expected to give advance notice of shifts in Treasury yields. However, it is possible for changes in Treasury yields (see “Three yields”) to lead changes in Eurodollar futures prices.
Because Treasury yields are more variable than 10-year T-note futures yields, changes on the chart of yield differences are caused primarily by movements in Treasury yields. Through the period covered by the data, the average daily absolute yield change for T-notes was 3.59% compared with an average change in T-note futures yields of 3.02%.
When Treasury yields increase more than the nominal yields on T-note futures, the price of the September 2008 Eurodollar futures contract falls while the yield difference declines. When the difference increases as Treasury yields fall with respect to
T-note futures yields, the decline in yields results in an increase in the Eurodollar futures price.
Both effects are made possible by the relative stability of T-note futures yields compared with Treasury yields. Movement in Treasury yields, acting through credit and convexity spreads, triggers changes in the quarterly rates on Eurodollar contracts for which the price equals 100 minus the rate.
On the “T-note/Eurodollar connection” chart there are several periods in which the T-note yield less Treasury yield differences leads changes in the price of September 2008 Eurodollar futures. Three of these are (1) Sept. 22 to Oct. 4, where differences decline before the futures price falls by 34 points, or $850; (2) Oct. 20 to Oct. 27, where differences rise in advance of a futures price increase of 12 points, or $300; and (3) Nov. 15 to Nov. 28, where an increase in differences precede a gain in the Eurodollar contract of 18 points, or $450.
This brief period of observations may have been one of especially volatile interest rates. In that case, the predictability of Eurodollar futures price changes by use of differences between T-note nominal yields and Treasury yields would not be as dependable when applied to more normal variations in market yields. As is true of any technical indicator, using yield differences requires a large amount of subjective judgment.
IT’S IN THE APPLICATION
Despite its potential disadvantages, ease of use should encourage some tests of the T-note/Eurodollar connection. Just two steps are needed to construct the difference at any time.
First, calculate the nominal yield on a hypothetical 6%, 10-year, $100,000 coupon note, based on the nominal 10-year T-note futures price listed by the CBOT. This yield is the discount rate necessary to make 20 semiannual $3,000 interest payments plus $100,000 at maturity at the end of 10 years equal to the nominal futures price shown by the CBOT.
“Calculation of nominal yields” (below) shows the solution for a 10-year T-note futures nominal yield. The nominal price is 107-120, or $107,000 plus 12/32nds of 1% of $100,000.
By adjusting the trial yield until the total present value of interest and principal cash flows approximates the CBOT nominal T-note futures price, the nominal yield may be calculated, in this example, to the nearest 10,000th of 1%.
Second, subtract the U.S. Treasury yield shown by Bloomberg.com (or a similar source) for a 10-year maturity from the nominal yield computed in the first step. This is the difference at a particular time that may be observed as rising or falling faster than the Eurodollar futures contract chosen for comparison, or merely reflecting the price movements of the Eurodollar contract.
As shown on “Three yields,” nominal T-note yields visibly match the movements in U.S. Treasury yields. It is the small differences, mainly due to the larger variability of Treasury yields, whose movements correspond with Eurodollar futures prices and may give advance notice of price changes.
Paul D. Cretien is a retired professor of finance at Baylor University and a chartered financial analyst. He wrote “The Basics of Bank Investments” (Graduate School of Banking at LSU, 2004). E-mail him at PaulDCretien@aol.com.
