Fresh Trading Ideas in Bond Futures
Mar 23, 2017
By: Sage Anderson
Despite the relative void in volatility that has overtaken financial markets since last November, there was some important news that hit the wires last week.
On the 15th of March, the US Federal Reserve's Open Market Committee (FOMC) voted unanimously to raise target interest rates by another quarter percent. This was only the third time the Fed raised rates since the Great Recession.
The Fed first raised rates a quarter percent in December of 2015, and then again by the same amount in December 2016. The most recent action means that the Fed, led by Chair Janet Yellen, has raised rates two times in the last three months.
The last time the Fed raised rates over the course of such a short window of time was 2006, when the FOMC raised by a quarter percent over consecutive meetings in Spring/Summer of that year.
Expectations suggest that further rate hikes could come in June and December of this year, although those potential moves are of course dependent on how the economy continues to perform (among other factors).
In the wake of this news, the question, of course, is how one might capitalize on current opportunities related to interest rates.
Fortunately, a recent episode of Closing the Gap - Futures Edition focused on this exact question. The primary focus of the show is the yield curve, which essentially provides a snapshot of interest rate expectations.
The yield curve is a chart that shows the rates of return on a similar set of bonds that have different maturities. Normal yield curves (like the one pictured below) tend to exist in rising interest environments. However, yield curves can also be flat or inverted - an inverted yield curve is downward sloping.
The current "normal" yield curve comprised of Treasury bills, notes, and bonds:
As discussed previously on tastytrade, it's important to remember that an inverse relationship exists between bond prices and interest rates. As interest rates rise, bond prices tend to fall, and vice versa.
This relationship exists because as interest rates rise, investors sell older bonds (that were issued with lower interest rates) in anticipation of buying newly issued bonds (that they expect will be issued with higher interest rates). The demand-supply equation consequently pushes down existing bond prices as more sellers appear than buyers.
Shorter-dated bonds can actually see a rise in demand even with interest rates rising, because investors selling longer-dated bonds often park their capital in shorter-term bonds while waiting for redeployment.
On the recent episode of Closing the Gap - Futures Edition, two potential trading strategies are discussed that may be of interest to traders looking for opportunities related to the yield curve. These strategies include:
the "flattener" - potentially leveraging a flat, or gradually rising yield curve
the "steepener" - potentially leveraging a rising yield curve
Depending on your outlook for the economy and interest rate policy, one of these trades may be an appropriate fit for your portfolio.
Because US Treasury products are available across of wide range of maturities (anywhere from 4 weeks to 30 years), traders can also tailor the trade structure to match their unique expectations.
Some of the more frequently leveraged relationships across the range of maturities in Treasury are listed below:
"TUT" spread: 2-year maturity versus 10-year maturity
"FITE" spread: 5-year maturity versus 10-year maturity
"NOB" spread: 10-year maturity versus 30-year maturity
On the show, the hosts walk viewers through the construction of a sample "TUT steepener." The “TUT” aspect of this trade means the trade involves the 2-year maturity and the 10-year maturity. The “steepener” component of the trade indicates the trade structure is hoping to leverage a rising yield curve by purchasing short-term bond futures (2-year, /ZT) and selling longer-dated bond futures (10-year, /ZN).
We recommend watching the full episode of Closing the Gap - Futures Edition for a comprehensive review of this material.
If you have any questions about trading interest rates, or the yield curve, we hope you'll reach out directly at firstname.lastname@example.org.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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