Currently, the yield curve for U.S. interest rate vehicles is particularly steep right now, a unique situation which may lend itself to interesting trading opportunities. The yield curve represents the relationship between interest rate instruments of varying maturities, from very short-term to very long-term. Interest rates are extremely low for short-term interest rate instruments (essentially near zero), while the long end is much higher (the U.S. Treasury bond rate is nearing 5 percent). This steep shape of the curve generally indicates inflation expectations are being priced into the market, and that interest rates will rise. People are demanding more return on longer-term investments to bear the risks involved. There is also an element related to the cost of borrowing built into the shape.
Understanding the yield curve is a great tool for evaluating the markets. It gives signals of what market participants feel might happen for the economy, and how they are allocating risk. You can formulate a trading and investment strategy based on these concepts.
First, let’s look at some of the fundamentals. Officially, the Federal Reserve’s job is to manage inflation, and traditionally they do this by managing interest rates. Lower rates stimulate growth in the U.S. economy because borrowers can access capital at cheaper rates. Developers, for example, can build more houses at lower prices because their cost of capital is lower. It also tends to increase the valuations of many assets, including stocks, which essentially represent the present value of future cash flows.
The Fed tries to manage interest rates primarily through the Federal Funds rate, the overnight interbank lending rate at the far short end of the yield curve. Oftentimes, the short end drives investor demand at the long-end. If you can’t get a decent return on a 30-day Treasury bill, for example, you might turn to a 10-year Treasury note or 30-year bond for a better return, or seek out other assets such as commodities or equities.
There are other factors at work affecting the yield curve. Federal borrowing in the U.S. has been in the news almost every day and the economic impact has been so great it has created a crowding out effect. It has been pushing rates up and making it difficult for other investors to borrow for long periods of time. If the U.S. Federal government needs to borrow money, it has to issue more Treasury bonds, increasing the supply and thus decreasing the price. That in turn increases the yield that has to be paid to investors.
U.S. Treasury Yield Curve
Fed Funds Rate
Creating Liquidity
To help control the long end of the curve, the Fed has another tool at its disposal, quantitative easing. It purchases Treasury bonds, and has to either print money or take cash from its reserves to pay for them. That cash goes into the hands of the bond sellers, expanding the monetary base. You can’t do this forever though. You end up with a liquidity trap, and likely, inflation. The Fed is trying to keep interest rates artificially low at the long end of the curve as well as at the short end, as are many other central banks in the world.
Right now we have the highest levels of liquidity in the U.S. economy, absent of a depression. It’s a unique situation in history, and we don’t have many clear historical comparisons. Interest rates are also low in Canada as well as in Europe, although not quite as low as in the U.S.
The Federal deficit has been the main force causing long-term rates to creep up. This U.S. deficit is at an historical high ($1.4 trillion). It’s hard to put it into context but you can see the magnitude of it on a graph.
This government borrowing is causing intense pressure on interest rate instruments, and the Federal Reserve (which is independent of the U.S. government) has had to use every tool in its arsenal to keep rates at a low level. The Fed has had to buy increasingly large amounts of Treasuries to keep long-term rates low. In the 1990s, the Fed rarely had more than half a trillion securities. Starting in the Bush era and through the present, the Fed has had to buy increasingly large amounts of Treasury securities. Obviously, they can’t continue to do so forever.
The Federal Reserve owns more than just U.S. Treasuries, as the interest rate markets are all pretty integrated. If Treasury securities rates are high, most likely mortgages will be high and corporate lending rates will be high. Federal agency securities (Fannie Mae and Freddie Mac) spiked during the financial crisis, and were then unwound. The Fed’s balance sheet has grown dramatically during the past decade, as they have purchased new categories of assets to flood the economy with money.
You can see how there was virtually no blip in the monetary base during crisis periods of the past two decades, other than tiny blips during the 2000s. More recently, the chart shows a dramatic spike, with the monetary base doubling, and nearly tripling. Eventually, if things go according to Economics 101, this all should result in inflation.
U.S. Monetary Base
Trading Strategies
As traders and investors, of course you want to know how to benefit from these developments. One of the ways is to trade Eurodollar futures. Eurodollars are deposits of U.S. dollars in banks outside the county. They are considered money market instruments, represented as a short-term certificate of deposit in U.S. dollars guaranteed by a bank outside the U.S. Many decades ago, banks in Europe would borrow and lend U.S. dollars among themselves at low rates. When banks want to lend to each other, they use what’s called the London Interbank Offer Rate (LIBOR).
Then in 1990, the euro currency came about, causing confusion ever since with the older Eurodollar product, which is based on short-term, low risk debt. Eurodollar futures prices reflect market expectations for interest rates on three-month Eurodollar deposits for specific dates in the future, and this is what I will be referring to when I discuss Eurodollar trading strategies.
On the next chart, we can see a yield curve in three month-slices, with each bar representing a Eurodollar contract. The Eurodollar yield curve we see here is typical of other yield curves in shape. You can trade the slope of the yield curve by trading one slice against another—such as the December 2016 against the December 2017 contracts. You can see the difference between these two interest rates is pretty narrow. As time passes the relationship between a given year-over-year spread will often widen, as you can see when looking at the December 2010 vs. 2011 contracts.
You can buy a Eurodollar spread when it’s narrow and hold it as it rolls along the yield curve, and you can also try to predict changes in the yield curve and monetary policy. You would basically bet on a spread getting wider if you thought the yield curve would steepen, for example. Trading spreads based on the Libor rates can be very complex, but once you get your mind wrapped around the concepts, some interesting strategies develop that are uncorrelated to others that may be in portfolio.
Implied Eurodollar Libor (LIBOR) Interest Rates
If you’d like more information on this topic, or details for a specific trading strategy that might be suitable to your unique situation, please feel free to contact me.
Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.
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