A lot can be learned from differences between the cash and futures markets of the same underlying. Consider the difference between the nominal yields on Treasury note futures and the yield on the actual T-notes. This spread varies with changes in the Treasury yield itself.
“Channel markers” (below) shows yield differences each day from Sept. 18, 2006, through March 9, 2007, with Treasury yields ranked from low to high. The differences range from 0.37 to 0.29 during this period and correspond to variations in the 10-year Treasury yield from 4.43% to 4.89%.
Differences calculated to two decimal places show that each difference is associated with a predictable range of Treasury yields. A difference of 0.32 corresponds to yields from 4.61 to 4.82, a 21 basis point range. The range of about 25 basis points describes the horizontal size of the difference channel over the time period observed, while the height of the channel at any yield is about 4 basis points.
When the Treasury yield is to the right side of the channel at any specific difference, the nominal yield less the Treasury yield is large relative to the current Treasury yield. Because the nominal yield is high, the T-note futures price is lower than expected and the possibility exists for a change to a higher price level.
On the other hand, when the Treasury yield is on the left side of the channel, the smaller difference between the nominal T-note futures yield and the Treasury yield indicates a lower than expected nominal T-note yield compared to Treasury yields. This, of course, forecasts the chance of a downward price move.
CHANNELS IN ACTION
Knowledge of the nominal yield less Treasury yield channel for T-note futures contracts should assist in determining whether nominal yields are in line with Treasury yields, or whether they are temporarily too high or too low. Although it is possible for the Treasury yield to be consistently high or low relative to the corresponding nominal yield less Treasury yield difference for a period of days or weeks, during this time there may be unusual spikes outside of the normal range.
It is these unusual variations between nominal futures yields and Treasury yields that may indicate trading opportunities lasting just minutes or hours — or possibly changes in the direction of the short-term trend in yields. Based on the channel borders, better estimates may be made of the risks and opportunities available on trades in nominal T-note futures.
As shown on “Channel markers,” above, there are many data points in the middle of the channel. However, enough fall near the edge to make measurement worthwhile. Look for Treasury yields that fall outside the channel to give advance notice of a change in direction for the nominal T-note futures price.
NEGATIVE RELATIONSHIP
Clearly, the difference channel slants down as we move to the right of the chart in “Channel markers.” The reason has to do with the relationship between the curves of Treasury note prices and T-note futures nominal prices.
“Price Curves” (below) charts the 10-year Treasury note price together with the 10-year T-note futures nominal price, confined to the range of the 10-year Treasury yield from 4.43% to 4.89%.
As the prices decline with the larger yields, the distance between the curves becomes smaller. In this range of yields, Treasury price changes are approximately 15% greater than T-note futures price changes for a given increase or decrease in Treasury yields.
However, describing the two lines of data in “Price Curves” as “curves” is almost a misnomer because both appear to follow a straight line progression. However, this is a matter of perspective, much like standing in your driveway and trying to see the curvature of the Earth’s horizon.
A longer-range view shows the noticeably curved shape of Treasury note prices as the yield changes from 0% to 25% (see “Convexity of 10-year T-note,” below).
On this chart the difficulty of seeing the curve from up close is illustrated by the size of the red spot at the upper left end of the blue dotted line. This spot covers the entire area of yields and prices shown on the “Price Curves” chart.
MAKING PREDICTIONS
A different view of the differences between T-note futures nominal yields and Treasury yields was presented in “All in the Family,” March 2007. During the period between Sept. 18, 2006, to March 9, 2007, the differences were shown to vary in response to changes in Treasury yields. Related to the slopes of the two yield curves, the daily changes in the nominal T-note yield were 84% of the average change in the Treasury yield.
When this relationship is used to predict the differences between the nominal T-note yield and the Treasury yield, forecasted differences are close to actual differences (see “Predicted vs. Actual,” below). This chart contains the same differences that are included on “Channel Markers,” except it presents the data through time instead of through Treasury yields that are ranked lowest to highest.
“All in the Family” also described the variations in differences as related to the timing and sizes of price changes in a Eurodollar futures contract during the same period, September 2006 to March 2007. Because Treasury yield increases and decreases determine T-note nominal yields as well as Eurodollar futures yields, the series of nominal T-note futures yields minus Treasury yields is closely correlated with Eurodollar futures price changes. Both are highly dependent on Treasury yields for the size and direction of their yield changes.
As a tool for indicating trading opportunities in T-note futures, the channel showing T-note futures yields less Treasury yields has the advantage of being easy to use.
The difference at any time is equal to the T-note futures nominal yield — either calculated by the process described in “All in the Family,” or by locating it on the nominal price and yield tables listed by the Chicago Board of Trade minus the 10-year Treasury yield listed by Bloomberg.com.
Throughout 2006 and early 2007, Treasury yields have been locked in a relatively narrow band of approximately 50 basis points. Continued use of the T-note difference channel as a price change predictor should be accompanied by updates of differences related to Treasury yields.
As market yields shift, the “Channel Markers” chart should be expanded to allow new data with the possibility of higher or lower ranges of Treasury yields. If Treasury yields increased far beyond the current top of around 5%, the slope of the channel could change; however, there will continue to be a range of yields associated with each difference when the differences fall below the chart value of 0.28%.
Although the charted differences are end-of-day data, probably the most valuable use of this tool would be intraday, using minute-by-minute updates of the yield values. Used as such, the “Channel Markers” approach provides an additional instrument for trading guidance related to Treasury note futures.
Paul D. Cretien is a retired professor of finance at Baylor University and a chartered financial analyst. He is the author of the book The Basics of Bank Investments (Graduate School of Banking at LSU, 2004).
