Betting on the fed

September 28, 2016 09:00 AM
As the Fed manipulates short-term interest rates to juice or slow down the U.S. economy, three-month Eurodollar futures offer traders a direct way to take advantage of moves in the market.

The close connection between rates and yields on three-month Eurodollar interest rate futures and the U.S. Treasury yield curve makes it possible, in turn, to relate Eurodollar futures to Federal Reserve policy because one of the Fed’s main tools is control of short-term interest rates. 

For much of the past decade, the Fed has kept short-term rates close to zero in an effort to bring the U.S. economy out of a serious recession. “Yields and rates” (below) shows the relationship between Eurodollar futures and U.S. Treasury yields. At each of the 40 quarterly maturities, the Eurodollar futures yield is the geometric average of the shorter-term quarterly rates.

 

Because the Eurodollar and U.S. Treasury yield curves are closely related, we can say that the invisible forward rates that combine to form the Treasury yield curve are approximately parallel to the Eurodollar rate curve with slightly lower rates. To keep Eurodollar yields in correspondence with U.S. Treasury yields, each of the 40 Eurodollar futures contracts has a specific position in relation to other Eurodollar futures as well as to Treasury yields. On charts, none of the rates is out of line as rates and yields form smooth chains during the 10-year span. 

The Fed influences Eurodollar futures because of its effect on U. S. Treasury interest rates. During the past decade, the shortest-term Eurodollar yield was close to the low yield on U.S. Treasury securities. The spread shown on “Yields and rates” occurred following the Fed’s decision in December 2015 to begin raising interest rates. The market has added basis points while the Fed ponders whether to raise short-term rates.

The Eurodollar and Treasury yield curves are relatively flat due to the rise in short-term rates as well as the reduction in long-term yields resulting from a rush to the safety of bond yields following Brexit — Great Britain’s vote on June 23, 2016, to leave the European Union.

Playing fed moves

Although Eurodollar yields cannot be traded, they do have influence over Eurodollar quarterly contracts that are traded. The key connection is the ratio of rates to yields.

“Rates-to-yields” (below) shows that through the years the ratio has varied in shape because the quarterly Eurodollar futures rates are responsible for keeping the Eurodollar yield curve connected to the U.S. Treasury yield curve. Most of the fluctuation in the rate-to-yield curve for Eurodollar futures takes place up to the five-year maturity because this is the range in which trading volume is heaviest.

Beyond the five-year maturity, there is little trading so that the rates are set primarily by market makers or market makers’ computers. This area of pricing might be called the Eurodollar futures “no man’s land.” One feature of no man’s land is that the rate-to-yield ratio is stable near 1.40 and 1.50. This means that a change in yield of 100 basis points should be reflected in a change in the longer-term Eurodollar rate of from 140 to 150 basis points. At the five-year maturity, it should be possible to profit from trading Eurodollar futures based on changes in longer-term U.S. Treasury yields with the rate-to-yield leverage.

The curves of Eurodollar futures quarterly rates-to-yields reached a peak at approximately the two-year maturity on several dates shown on “Rates-to yields.” A peak in short-term rates-to-yields for Eurodollar futures is caused by Eurodollar rates forcing yields low enough to match the Treasury yield curve – a process previously described as short-term Eurodollar rates doing “heavy lifting.” 

“Yields and rates” demonstrates what happens when the short-term rates avoid heavy lifting. In this case, Eurodollar short-term rates are approximately 50 basis points too high with respect to the Treasury yield curve. This allows the Eurodollar curve to float above the Treasury curve until the two curves match at the five-year maturity. 

It may be that the separation at the shortest terms is caused by market expectations of the Fed raising rates.

A trade at this time, taking a long position in short-term Eurodollar futures, and short non-Eurodollar contracts such as interest rate swaps or Treasury notes, may result in profiting from the 50 basis point, $2,500 spread at the shortest maturity. A positive result depends on the gap between yield curves shrinking as short-term Eurodollar rates resume their heavy lifting duties.

Price curve analysis

Although there are 98 put and call prices listed on Barchart.com for the September 2016 expiration of Eurodollar options on July 15, only a handful are possible data for price curve calculations. The others are either too far in-the-money where the price is equal to the intrinsic value, or too far out-of-the-money with the price shown at some small constant value such as 0.0100, or $0.25.

In the listed data on July 15, the lowest strike price is 92.000, indicating 8% for a Eurodollar futures rate. The price of the September 2016 call on July 11, was $18,250. It’s fair to say that some traders within the past 10 years may have made the correct decision with a long position on September 2016 Eurodollar futures. 

If these holders of September futures are betting on the Fed now, they may decide to take their gain before rates increase and diminish the profit they currently hold.

For example, on Feb. 1, 2007, the September 2016 Eurodollar futures had a price of 94.250 with a rate of 5.75%. On July 15, 2016, the September 2016 futures contract was priced at 99.250 with a 0.750% rate. At $2,500 per option point, the gain on the original futures will be $12,500 if taken on this July 15.

Usually the trading volume on Eurodollar futures past the five-year maturity is small to nonexistent. On Feb. 1, 2007, the September 2016 futures contract was the next to last, or the 39th out of 40 quarterly contracts. The trade would not have been impossible, just unusual. In the current market with historically low rates, there are probably traders taking a short position in June 2026 Eurodollar futures with a price of 97.790 and a 2.21% rate. The trading volume in that contract on July 15 was 47.

For the September 2016 futures, there have been many opportunities to go long on maturities within the five-year range of higher volumes. As shown by “History of September 2016” (below), the most profitable time came following the Fed’s actions to reduce short-term interest rates to approximately zero. The red dot representing the position in September 2016 futures continues down the rate curve with increasing profitability, while the rate history may indicate the end of an era.

Cross markets

While Eurodollar futures are priced according to changes in quarterly interest rates, other financial contracts are valued in terms of the present value of interest cash flows. This means five-year and 10-year T-note futures have price changes computed by yield-to-maturity instead of by a 90-day rate. The price curves as interest rates and yields change are different between financial assets that have convexity (slower to decline in price as yields increase and faster to climb in price as yields fall) and Eurodollar futures that have a constant straight line price change of $25 per basis point of rate change.

Analysis of September 2016 five-year and 10-year T-note futures — computing price curves of predicted prices, delta values for each of 11 strike prices, and breakeven prices assuming a delta trade on July 15 — produced the results shown on “Predicted changes” (below). The five- and 10-year futures forecast an almost equal spread in yield between the upper and lower breakeven prices; however, the 10-year T-note is almost twice as volatile as the five-year T-note. 

“T-note call options” (below) shows the price curves with increased volatility of the 10-year T-note evident based on the difference in the heights of the curves.

A price curve computed for June 2017 Eurodollar options on July 15, 2016, resulted in a breakeven rate spread between 1.303% and 0.542%. The analysis was based on strike rates instead of strike prices, and produced predicted put premiums that are equivalent to calls because Eurodollar prices rise when rates fall. 

The underlying futures rate on July 15 was 0.915% and the eight strike rates ranged from 1.88% down to 1.00%. 

Based on the analyses above, it could be said that the futures and options markets are not forecasting great changes in rates and yields at this time. Perhaps it is the mode of the current time to be more conservative in actions as well as forecasting, and to believe that the causes of change will be correspondingly subdued.

About the Author

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.