During the first week of June 2007, the interest rate market experienced something it hasn’t seen for over a year and a half — a significant increase in Treasury yields. Results from this change included large losses in the prices of Treasury note futures and Eurodollar futures. It also gave the structure of Eurodollar quarterly rates and yields a new look.
The revised layout of rates and yields is shown on “Comparative yields” (below). This includes Eurodollar quarterly rates and yields for May 17 and June 14, 2007. On May 17, Eurodollar rates were forced to arrange themselves in an unusual downward curve and then reach upward along a straight line for the Eurodollar yield curve to correspond to Treasury yields, taking into consideration the appropriate credit and convexity spreads.
After the sharp increases in Treasury yields in early June, Eurodollar rates and yields took on a new shape. This shape is shown on June 14. At this time there is no longer a downward curve to start the flow of quarterly rates. The initial quarterly rates begin approximately at the level of the Federal Reserve’s rate on short-term funds, which is 5.25%. Following a horizontal move to the sixth quarter, both the rates and the resulting yield curve are straight lines extending up to the maturity of 10 years.
The Eurodollar yield curve will continue to adjust to any new shape of Treasury yields. Currently, the yields form straight lines because Treasury yields are relatively flat as they extend out to 10-year maturities. On June 14, as reported by Bloomberg.com, the yields were 5.08%, 5.11%, 5.14% and 5.20%, for maturities of two, three, five and 10 years, respectively.
MULTIPLE SPREAD BENEFITS
It is possible to use several yield spreads to improve chances for trading profits from interest rate moves, and to protect against adverse changes in case of interest rate increases such as those during June 2007. Two of the spreads are directly based on Eurodollar yields — Eurodollar yields less Treasury yields, and Eurodollar yields less the yield on nominal 10-year Treasury note futures (T-notes). The third, and probably the best, is the spread between nominal T-note futures yields and Treasury yields.
“Eurodollar spreads” (below) includes the Eurodollar yield less Treasury yield and the Eurodollar yield less nominal T-note futures yield through the period from Sept. 18, 2006, through June 14, 2007. There are two short-term trends suggested by the yield spreads — the first one ending at the first of December 2006 and the second extending from that date through mid June 2007.
Around the trends are several intermediate peaks and troughs, but the two general movements observed are first toward lower yields and then gradually moving to the highest yields in June 2007. The area between the two Eurodollar spreads equals the spread between the yields on nominal T-note futures and Treasury bonds and notes. This spread is seen more clearly on “T-note futures spread” (below) with data shown over the Sept. 18 through June 14 period.
These movements in the T-note futures yield less Treasury yield spread are reflected in Eurodollar futures prices. We can see these in “Effect on futures” (below), which shows price changes for the September 2008 quarterly contract.
FORECASTING PRICE CHANGE
There are several points at which the spread may have provided advanced warning of a change in the price; however, the most noticeable area is the one that starts in early April 2007 and extends toward the end of May. During this time, the spread between the yields on T-note futures and Treasury securities remained relatively flat. Meanwhile, the price of the Eurodollar futures contract dipped in the first week of April and then began a new move up to a peak on April 23.
The spread between the T-note futures yield and Treasury yield generally moves in response to changes in the Treasury yield. As described in “Channeling T-note Futures,” July 2007, Treasury yields are more variable than T-note futures yields and this causes the movements in the spread to reflect changes in Treasury yields, which in turn are the cause of price movements of the Eurodollar futures contract.
Because T-note futures and Eurodollar futures move in response to Treasury yield changes — and because the cause and effect sequence is usually predictable — a variation that has Eurodollar futures prices increasing while the T-note/Treasury spread is flat should put traders on guard. Either Eurodollar rates were lower than they should have been, or the nominal yield on T-note futures was too low with respect to the Treasury yield.
Charts of Eurodollar futures rates and yields, such as those on “Comparative yields,” confirm the remarkable degree of control that institutional programs exert over the Eurodollar futures market. If this is so, how do the variations in Eurodollar spreads coordinate with the carefully constructed structure of Eurodollar rates and yields?
On a minute-to-minute basis, the prices listed by the Chicago Mercantile Exchange, as well as the invisible rates and computed yields, form smooth lines or curves extending over most of the 40-quarter maturities. The 10-year maturity used in the previous examples is the end of a progression of yields that are formed by quarterly rates with the objective of matching the Treasury yield curve — after inclusion of spreads for credit and convexity differences.
Do the variations in Eurodollar futures credit spreads indicate loss of control in a market whose rates and yields are almost totally controlled?
It is possible that forces external to the futures market are the causes of the short-term trends in the spreads noted above, while variations around those trends are held in check by the computer-based programs that form the otherwise smooth curves of quarterly rates and yields.
Structured pricing seems to work to the benefit of traders who speculate or hedge in the Eurodollar futures market. Variability in a controlled environment implies potential profits with less risk. Observing variations around the trends as they occur is the key to reducing risk while increasing trading returns.
As the rotation of Treasury yields continues, bookend pricing of Eurodollar futures (see “Eurodollar bookends,” June 2007) will necessarily evolve into more exotic curves.
On June 14, 2007, however, the straight-line bookend yields are still in evidence, with the series of sloped rates and yields beginning at the sixth quarterly contract.
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).
