Interest rates remain at generational lows in Canada. Will it last? Hawks believe inflation is here in all but the official statistics. They are buying gold as an inflation hedge, which they believe will eventually require high interest rates to control. Bond bulls look to Japan and the ongoing decade-long fight against deflation being waged with ever-larger debt stimulus spending. Who is right? How can we benefit from our opinion regarding the outcome of this serious economic debate?
The futures markets in Canada offer almost the same breadth of interest rate contracts as those in the United States. At CME Group in Chicago, traders can short U.S. 10-year Treasury bills if they believe interest rates are headed up (futures prices trade inversely to yield). Conversely, if traders believe deflation will continue trending, they will bid up U.S. long bond (30-year Treasury) futures.
In Montreal, Canadian investors can trade the CGB futures, the 10-year government of Canada bond futures contract, to gain exposure to Canadian interest rates trends. The Montreal exchange also offers a Canadian long-dated bond called the LGB, similar to the U.S. 30-year Treasury bond contract traded in Chicago. Spread trading between Canadian and U.S. interest rate markets can also be profitable for those with a prescient view of the differences between the two North American economies’ growth – or lack there of.
However, trading the two markets, Montreal and Chicago, entails currency risk. When trading across borders, a spread with each leg priced in a different currency will require dynamic rebalancing, as the exchange rate fluctuates daily. A more straightforward way to play the spread between interest rates in Canada and the U.S. uses currency futures and the cost-of-carry differential between delivery months in the Canada dollar futures priced in U.S. dollars. Currency risk is mostly eliminated compared with the bond futures spread. For the currency futures calendar spreader, the risk is only at the opening of the trade when converting Canadian dollars to U.S. dollars, and when closing out the trade and converting profit/losses back into Canadian dollars. No daily rebalancing is required as in the U.S./Canada bond spread.
How does it work? All futures contracts are priced basis the cash market. Assets that cost to carry into the future will be priced higher the further out in time they come up for delivery. For example, gold costs money to store and insure, so its market price will normally be higher further out in time the contract for the gold delivery extends.
Conversely, assets that earn money, such as higher interest bearing currencies, will be lower in price than the “cash” price the further into the future the delivery month extends. As interest rates spread wider apart between the U.S. and Canada, the Canadian dollar futures’ price between nearby months and further-out months will widen even more. Right now, Canadian and U.S. rates are roughly similar. In the U.S., the overnight lending rate has been locked at 0 – 0.25 percent since December 2008, while in Canada, the rate was moved up to 1 percent in April.
At the time of the Bank of Canada’s rate decision, the Canadian dollar calendar spread priced in higher Canadian short-term interest rates and the Canadian dollar traded at 1.055 to the U.S. dollar. It has narrowed significantly since April just as the BAX (three-month money futures on the Montreal Exchange) has rallied relative to the U.S. Fed Funds futures. It seems U.S. rates have been steady in the past six months, but relative to Canada’s three-month money yields, Canada did enjoy a rate premium to the U.S. government debt market in April, but not since the April rate setting by the BOC. We see this in the further forward price of the C$ being higher now than it was in April relative to front-month futures. This is probably due to the short-term money rates (three-month rate) rising in April, but subsequently falling back to the average for the year so far as we move through June 2011. In time, will the U.S. central bank (the Federal Reserve) be forced to raise rates outrageously to attract capital to fund the country’s enormous deficit? Can Canada’s superior fiscal position allow the Bank of Canada to moderate interest rates lower than south of the border, keeping the Canadian dollar cheaper? Or, will the risk premium attached to the smaller Canadian economy require Canada’s rates to move in lockstep, or even higher than U.S. rates? The up-front cost of trade is relatively inexpensive at only $101 U.S. dollars initial margin (subject to change).
Intra-commodity calendar spreads attract very small margin requirements. This makes using currency futures an efficient tool to speculate on the rate spread between the U.S. and Canada. What is the result? By being long the nearby C$ futures and short the C$ contract one year out, a trader hopes interest rates go up in Canada faster/higher than in the U.S. during the term the spread trade is open. By how much will the position gain per discrete move in the interest rate differential? We can estimate the potential profits using the interest parity equation. (See Wikipedia for an explanation of this equation)
Effectively, the spread between the nearby and the further-forward futures will be equivalent to the difference in the interest rates between the two currencies. In other words, if Canada raises rates to a premium of 1 percent against U.S. rates, then the futures contract one year out from the nearby futures for the C$ will drop in price by approximately 1 percent.
With a notional value of $100,000 a 1 percent change in value is equal to $1,000, or 10 times the margin deposit for the position (not including commission.) Then again, if the U.S. raises rates by 1 percent before Canada does, the Canada dollar will likely fall versus the U.S. dollar. The C$ spread sellers will benefit as the Canada dollar futures’ back months one year out will rally versus the Canada dollar spot month by a proportionate amount, similar to the latter example. Similar to a TED spread trade (difference between three-month Treasury bills and Eurodollars) the point spread between front and back months can vary wildly as a flight-to-quality depresses U.S. Treasury yields and drains bids from the Canadian fixed income market. This will increase yields in Canada relative to the U.S., and will depress the value of back-month currency quotes relative to front-month C$ quotes (direct, i.e. C$ in terms of the US$ units.)
To chart the spreads, you can use a free service from FutureSource. Use the Custom Charts link to learn how to develop spread charts. Hint: keep the spread constant through time by using the continuous front and back months, subtracting the back month from the front month e.g. =’QCD 1! – ‘QCD 4!’ The spaces and single quotes are important. The number indicates how many serial months forward in the cycle for that particular symbol. Currencies trade in 3 month intervals so ‘4!’ means 3 months times 4 or a one year continuous forward. You can also use the ‘Spread’ chart utility in Futuresource to view the calendar spread synthetically.
If you have any questions about this topic or would like more information about specific trading strategies, please feel free to contact me.
Chris James is in Business Development in Lind-Waldock’s Toronto office. He can be reached at 1-800-268-9294 or via email at cjames@lind-waldock.com.
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