Recent events in the U.S. credit market highlight the importance of monitoring the Treasury-note futures channels described in “Channeling T-note futures,” July 2006. By reviewing how these events cascaded through the Treasury market, we can better understand how to utilize these channels in the future.
Increases in U.S. Treasury yields in June 2007 extended the length of the T-note futures channels. The original spreads between T-note futures yields and U.S. Treasury yields were observed between September 2006 and March 2007. These are shown by the black dots on “Adjusting for yields” (below).
Red dots on the two charts show the evolution of the channels from March 12 through July 31. During this period, Treasury yields increased. The 10-year T-note futures nominal yield advanced from 4.56% to 4.74% and reached as high as 5.12% on July 12. The five-year T-note futures yield increased from 4.50% on March 12 to 4.57% on July 31, with a series of yields above 5.00% during the first week of July.
As expected, based on the convex curves of T-note yields relative to Treasury yields, as the Treasury yields increased the spread between T-note yields and Treasury yields declined, with the objective of being approximately zero when the Treasury yield equals the 6% nominal coupon rate of T-note futures contracts.
The economic world and interest-rate markets in particular were shaken in July 2007 by credit problems in the mortgage industry. As numerous companies involved with credit led by those dependent on sub-prime mortgages faced mounting problems, massive amounts of liquidity was provided to the financial market by the Federal Reserve, foreign central banks and by investors in equities who sought less risky securities such as those issued by the U.S. Treasury.
As liquidity flowed to this segment of the market, Treasury yields began to decline. One result was a retreat by T-note futures/Treasury yield spreads back up the 10-year and five-year channels. Yellow dots, marking spreads from Aug. 1 through Sept. 14, 2007, appear on the left side of each chart.
On the five-year chart the data show that T-note-Treasury spreads stayed within the previous channel as Treasury yields with five-year maturity fell from 4.57% on July 31 to 4.05% on Sept. 14.
On the other hand, 10-year spreads were primarily lower than the original channel from July 31 through Sept. 14, as 10-year Treasury yields moved from 4.74% to 4.46%. As indicated in the article “Channeling T-note futures,” when spreads between T-note yields and Treasury yields of the same maturity are close to the top or bottom of a channel, it is possible that the T-note futures contract is undervalued or overvalued, respectively, in relation to the Treasury yield.
According to this valuation concept, without taking other factors into consideration, 10-year T-note futures may have been slightly overvalued between Aug. 1 and Sept. 14. The extent of the over-valuation appears to be relatively small because all of the yellow dots are within five basis points of the channel’s lower boundary.
Channel indicators depend on the relative location of T-note futures and U.S. Treasury yields. A prediction of an up or down move in the T-note futures price may be quickly reversed by a change in the Treasury yield.
At the same time, the spreads between T-note futures and Treasury yields of the same maturity appear to be relatively stable, remaining at the same level through several Treasury yield changes. For this reason, it may be possible to predict what the T-note futures yield should be, given a change in the Treasury yield.
PREDICTING YIELD
From June 8 through July 18, 2007, the 10-year Treasury yield varied from 4.99% to 5.26%, while the T-note-Treasury yield spread varied from 21 to 25 basis points. Using 23 basis points as the market’s “favored” spread between 10-year T-note yields and 10-year Treasury yields, the accuracy of forecasted yields is shown on “T-note yield predicted” (below).
A chart of 10-year, five-year and two-year nominal T-note futures prices (“T-note futures prices,” below) reflects the effect that changes in Treasury yields of like maturities had on the futures prices from September 2006 to September 2007. During this time, there are two notable troughs in prices (in January and June 2007) and three peaks (December 2006, March 2007 and possibly September 2007). The last peak owes much to the decline in yields produced by the infusion of liquidity referred to above.
The price range for two-year T-note futures is smaller than price variations of 10-year and five-year futures. There are two reasons for the smaller price range. First, the short maturity prevents yield changes from having a large effect on price movements. Second, the Federal Reserve’s policy of holding the shortest-term interest rate at 5.25% throughout 2006 and three-quarters of 2007 kept short-term yields from varying far from the preset level determined by the Fed. Longer-term five- and 10-year yields were free to be more responsive to market forces.
A narrower price range does not prevent two-year T-note futures from being profitably traded, both speculatively and in hedging strategies. It is also possible to use T-note futures and Eurodollar futures with similar maturities in hedges or spreads. An example is shown on “Cumulative changes” (below), which shows changes in the yield on two-year T-note futures and movements in the price of December 2009 Eurodollar futures.
The yield on two-year T-note futures is computed as the discount rate required to make four semi-annual payments of $3,000 each and $100,000 at the end of two years equal to the price listed by the Chicago Board of Trade, when the price listed as percent of par plus 32nds of face value is converted to dollars. Eurodollar futures prices are listed by the Chicago Mercantile Exchange as 100 less the interest rate assigned to a specific future quarter.
Starting on Aug. 8, 2007, when the two-year futures price was 102-08, or $102,250, and the December 2009 Eurodollar futures price was 95.840, cumulative changes were computed each day through Sept. 14. The chart shows correspondence between the two series of cumulative basis point changes. There are points at which the spread between the two increases, indicating possible trading locations.
Assuming that Eurodollar futures follow Treasury changes, purchases or sales of the December 2009 contract might have been indicated at several places, including Aug. 17 and Aug. 29. Cumulatively, the price change for the two-year T-note futures indicated by the scale at the left of “Cumulative changes” is 60 basis points and a price increase of $1,141. For the Eurodollar December 2009 futures, there is a cumulative change of 49.5 basis points, each worth $25, for a total price increase of $1,237.50.
During each day’s trading, frequent updates of the two series may lead to short-term profits when price and yield changes signal possible moves in Eurodollar futures. A similar chart should be useful for the five-year maturities, combining the five-year T-note futures yield with a five-year Eurodollar futures contract.
“Three yields” (above) shows the relationships among 10-year maturities of T-note futures, U.S. Treasury securities and Eurodollar futures. The chart includes a period in which the Treasury yield is rising rapidly while the T-note futures/Treasury yield spread grows smaller (May 7 to June 12), and this is followed by a decline in the Treasury yield accompanied by a T-note-Treasury spread that stays narrow from top to bottom of the Treasury yield change. As indicated earlier, this throws the T-note/Treasury spread out of its channel on the low side.
During September 2006 to June 2007, the Eurodollar/Treasury yield spread stays relatively constant. Following the credit crisis from June to September, the Eurodollar/Treasury spread becomes wider, reflecting worsening credit conditions worldwide. Eurodollar futures are indicators of credit risk beyond the risks associated with Eurodollar deposit banks.
As economic and credit conditions improve, changes in the “Three yields” series should include a narrowing of the Eurodollar-Treasury yield spread. When Treasury yields start to increase once more, convexity should keep the T-note futures/Treasury spread from becoming wider.
CAUSE & EFFECT
Given the close relationship between interest-rate futures contracts (illustrated by T-note and Eurodollar futures) and the underlying, it is natural to think of the influence that the futures market must have on the cash Treasury market.
However, there are two factors that provide some assurance that the influence flows from Treasuries to futures and not the reverse. First is the contorted shape that Eurodollar rate and yield curves must achieve to match the underlying Treasury yield curve.
It would seem impossible for the participants in the interest-rate futures market to independently create these curves without the need to match movements in Treasury yields. Second, the larger variability of Treasury yields and prices suggests that T-note and Eurodollar futures may be relatively passive followers of Treasury yield changes.
While individual traders and organizations dealing in interest rate futures may have ideas about future interest rate and yield movements, the market itself seems to ignore any consensus of opinions and is consistently priced according to hedging rules. T-note futures and Eurodollar futures are matched with current Treasury yields at various maturities after provision for the usual spreads for convexity and credit risk.
Potential opportunities for price and yield spreads are shown by variations within T-note futures-Treasury yield channels. While the outcome of a specific trade suggested by the variations depends on movements of the Treasury yield, spreads may remain stable through multiple Treasury yield changes (again, see “T-note yield predicted”). The consistency of differences between yields may permit profitable spread trades, along with the risk of reversal due to movements in Treasury yields.
The price and yield charts show slow cycles, with trough to peak changes occurring approximately each 60-day period from September 2006 to September 2007. This cyclical movement may continue, dependent on economic factors that are the ultimate cause of interest rate changes.
Because interest yield spread changes are more or less repetitive, they provide an excellent trading environment. With relatively stable interactions between the major price and yield providers, the remainder of 2007 and 2008 may offer good opportunities for hedging and speculation in T-note and Eurodollar futures.
Paul Cretien, CFA, is an investment analyst and financial case writer. He may be e-mailed at PaulDCretien@aol.com.