From the July 01, 2011 issue of Futures Magazine • Subscribe!

How bond yields predict price action

Each day in the bond market, the future economic hopes of entire countries are negotiated as every tick of every interest basis point is speculated on by traders. Economic reports often act as a match to dynamite, resulting in explosive flurries of buying and selling as bond traders double-down or hedge risks on the future prospects of nations.

The risks are incredible, but so is the profit potential. However, to take advantage, you must have a solid trading approach combined with sound risk control. Fortunately, bonds trade in an event-driven market where economic reports result in predictable patterns that manifest in a bond’s price action and can result in a solid stream of profitable opportunities.

To capitalize on those opportunities, you must understand both how bond yields work and why they are critical to helping you profit across a broad breadth of asset classes.

Yields reveal the way

The U.S. Treasury conducts a number of bond auctions during the fiscal year to raise money to fund the various arms of the government as well as provide public services to its people. With the ability to print its own money as well as raise revenue in various types of taxes, the United States is a stable country with a strong economy that offers you, the investor, a strong guarantee that it has both the ability and the willingness to repay its debt to you, the bond-holder.

One of the instruments that it auctions is the 10-year Treasury note (T-note).

These notes are sold in $100 increments. For each sold, the U.S. government pledges to pay back $100 to the holder at a maturity date of 10 years from the time it was issued. These notes also have a fixed rate of interest that the Treasury sets at the time of the auction to give potential holders the incentive of a premium.

This premium, or interest rate, multiplied by the face value of the note, results in the expected yield for that particular note. So, if the United States is offering 3.50% on a $100 10-year T-note, then your expected yield is $35.

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