As part of its effort to stimulate economic growth, the Federal Reserve recently has invested its funds in longer-term securities rather than concentrating on the short-term end of the yield curve. Greatly reduced short-term rates over the past several years have not had the economic effects that were expected of them, and this has resulted in a certain amount of frustration by the central bank. After all, one of its roles is to support and promote sustained economic growth, and that has been hard to come by recently.
Richard W. Fisher, president of the Federal Reserve Bank of Dallas, has questioned the need for additional liquidity, pointing out the trillions of dollars of excess bank reserves on deposit at the Fed and additional trillions in the hands of corporations and money market funds. In essence, current monetary policy illustrates the maxim that “you can’t push on a string.” It is easy for the Fed to pull down a surging economy but difficult to reverse the process.
Over the past several years, interest rate forecasters frequently have noted that higher rates are just around the corner, having dropped so low that the only way is up. However, with the economy still wallowing in liquidity, rates remain incredibly low.
One way to measure the impact of Federal Reserve policy, and to describe the condition of interest rate markets, is to look at the yield curve generated by Eurodollar futures, an excellent proxy for the U.S. Treasury yield curve through the first 10 years of yield-to-maturity.
Eurodollar yields are calculated from the quarterly rates on futures contracts as a progression of geometric mean rates. The resulting curve is close to the U.S. Treasury yield curve because of constant arbitrage trading between Eurodollar futures, interest rate swap futures and Treasury note futures.
“Eurodollar yield curve” (below) shows the curve of geometric mean rates over 40 future quarters. U.S. Treasury yields appear at several maturities as dots slightly below the Eurodollar yield curve. On Oct. 10, 2012, the distances between the two curves were small, extending from 20 basis points at the shortest maturities, including the five-year maturity, to one basis point at the 40-quarter maturity. At five years, the U.S. Treasury yield is 0.65% while the Eurodollar futures yield is 0.8539%. Yields on accompanying futures that typically are used for hedging or spread trades are December 2012 five-year interest rate swaps with a yield of 0.8525% and December five-year T-notes with a 0.96% yield.
“Ratios of rates to yields” (below) shows Eurodollar quarterly rates relative to the Eurodollar yields at each quarterly maturity, with curves for Jan. 6, 2011, April 11, 2012 and Oct. 10, 2012. The curves “flex” with a change in market yields, rising with lower interest rates and decreasing when yields increase. When the Federal Reserve causes U.S. Treasury yields to fall, the distance between Eurodollar rates and yield curves increases; the opposite happens when Treasury yields rise.
Profits & losses
Eurodollar futures trading gains and losses are derived from changes in quarterly rates at $25 per basis point, while futures on T-notes and interest rate swaps have price changes based on yield-to-maturity. The flexing of Eurodollar futures rate-to-yield curves adds to or subtracts from spreads between Eurodollar futures and swaps or T-notes.
For example, from April 11 to Oct. 10, the March 2017 (20th quarter) Eurodollar futures gained $2,375 as the quarterly rate declined by 0.95%. During the same period, five-year interest rate swap futures increased in price by $2,984 with a yield change from 1.424% to 0.8525%. During this period of declining rates and yields, the ratio of rate-to-yield at the five-year maturity increased by 0.25, reducing the price gain for the 20th-quarter Eurodollar futures relative to the increase in price for five-year interest rate swaps.
The present yield curve can be put into historical context in “U.S. Treasury rate history” (below), which shows Federal Reserve constant maturity data for three-month, one-year, five-year and 10-year rates from January 1982 to September 2013. Over the 30-year period, there are five interest rate cycles in which rates fell to bottoms that are successively lower than the previous low, including the current low rates that are presumably resting on or near the ultimate bottom.
A steep yield curve shows up clearly in the last three downtrends, and the patterns in the cycles are similar. With each steep drop in rates, the five-year and 10-year rates follow the short-term rates down, but more slowly. This creates more space between short-term and longer-term rates, increasing the slope of the U.S. Treasury yield curve. In terms of relative space between long-term and short-term rates, the current yield curve was approximately as steep as the previous two downturns before the similarity was shattered by recent quantitative easing involving the purchase of longer-term securities by the Federal Reserve.
Sharp upswings in the three-month and one-year rates generally show the Federal Reserve policy of controlling overly exuberant economies with reduced liquidity, leading to higher short-term rates. The five-year and 10-year rates form a relatively smooth downtrend following a peak in 1990, with short-term rates first escalating in response to Federal Reserve tight-money policies and then falling sharply as the economic bubble burst. The chart also shows the repeated cycle of the Fed fighting price inflation (another of its mandated objectives) by absorbing liquidity, followed by infusion of liquidity in an attempt to restore economic growth.
The most recent episode of Federal Reserve actions leading to an economic downturn is shown in “Yields and rates” (below). The peak in 2007 is typical in that short-term yields are higher than long-term yields in an inverted yield curve produced by a policy of selling short-term Treasury securities by the Federal Open Market Committee. The shortest-term yield is 5.4% while the five-year and 10-year yields are approximately 4.8%. Eurodollar quarterly rates always have to be adjusted so that the Eurodollar yield curve is close to the U.S. Treasury yield curve.
On Feb. 1, 2007, the market could not quite achieve this objective, but its valiant attempt made the Eurodollar quarterly rate curve dip under the Eurodollar yield curve. Thus, Federal Reserve policy caused Eurodollar futures to have an inversion of their own because Eurodollar quarterly rates usually are higher than the corresponding yields.
“U.S. Treasury one-year rate” (below) presents both sides of rate history, increasing and decreasing from April 1953 to September 2012. Starting with low rates in 1953, the one-year rates increased to 16% in 1981 as inflation and real estate prices carried yields and rates to historically high levels.
What do the longer-term charts imply for futures rate and yield changes? A glance at the rate history charts suggests that 2% for short-term rates and 4% for longer-term rates would be a reasonable intermediate forecast. The timing is problematic because of a current slow economy with the Federal Reserve continuing to add liquidity; however, a three- to four-year objective may be appropriate, with a rapid increase in short-term rates beginning sooner than that. Perhaps the next short-term rate peak with intervention by the Fed will take place in 2015.
In the meanwhile, with rates and yields beginning to rise and the Eurodollar rate-to-yield flex curve descending, a long-term strategy of long 20-quarter Eurodollar futures and short five-year interest rate swap futures is a trade strategy to consider.