Traders that frequently monitor interest rates, or those that would like to get more involved in this niche of the financial markets, will definitely want to review a recent episode of Options Jive.
The best thing about this episode is that it highlights some big moves in rates expectations which occurred recently. This information not only provides traders with valuable insight on the market's expectation for the US economy, but it also lays out a sample trade structure that may be worth following in the foreseeable future.
What initially grabbed the attention of the market was the fact that expectations suddenly shifted regarding interest rates. As most are already aware, the Federal Reserve uses interest rates as a tool to help manage the US economy.
In general, this type of intervention typically materializes in the form of interest rate increases or cuts. When the economy is humming, the Fed often raises interest rates to slow down the consumption of credit. And when the economy is struggling, rates are typically lowered, to catalyze consumer and business lending.
In recent months, a wide range of economists and other analysts had suggested that the likelihood for a recession in the US was increasing. While no known model exists that can perfectly predict if or when a recession might actually set in, there are certain data points which can point to that eventuality. One such indicator is when long-term interest rates drop below short-term interest rates.
A few weeks ago, the perceived likelihood of the Federal Reserve cutting interest rates in 2019 had been minuscule. After all, the Fed had actually been raising interest rates in 2018, and only indicated at the end of last year that they were reevaluating that stance.
Well, things apparently have taken another turn. In their March meeting, the leaders of the Federal Reserve struck an even more dovish tone. In the wake of the meeting, new expectations for ongoing interest rates quickly rippled through the financial community. In short, the probability that the Federal Reserve would cut interest rates at some point in 2019 basically doubled.
Based on current data, the chance for a rate cut by the Federal Reserve before the end of 2019 now stands at nearly 65%. And because of the strong inverse correlation that exists between interest rates and bond prices, the change in expectations catalyzed a big rally in bonds and related products. Exhibit A are Eurodollars (/GEZ0), which experienced three 2+ standard deviation moves to the upside over the course of five trading days in late March, as you can see in the chart below:
While interest rates traders have a lot of products they can choose from - covering a wide range of maturities out in time - Eurodollars are somewhat unique because they are the only product that allows for direct exposure to short-term rates. Short-term rates are also the most correlated to actions by the Federal Reserve.
The Fed is, after all, basically dictating short-term rates in the US economy, while longer-term rates are priced by the open market.
One way of looking at long term interest-rates, by the way, is to think of them as the market's expectation for short-term rates at various points in the future. That’s why a drop in long-term rates, below the levels of short-term rates, can be such a strong indicator of expectations for the ongoing economy. This usually means traders are expecting a contraction in the economy, which would in turn require intervention by the Fed (i.e. a rate cut).
The nice thing about Eurodollars is that aside from providing traders with the ability to express their opinions on short-term rates, they are also pretty easy to understand from a valuation perspective. As a reminder, Eurodollars are US Dollar-denominated assets held in overseas banks (i.e. outside the USA) or in the overseas branches of American banks.
By using just a few simple inputs, traders can get a very quick idea of not only the current price of Eurodollars, but also where short-term interest rates are trading. This is done through the following calculation: Yield = 100 - Eurodollar Price. If Eurodollars were currently trading at a value of 97.33, that would mean that the yield would be 2.67% (100 - 97.33 = 2.67).
Looking back at historical data in Eurodollars, one can see that during the Great Recession, when interest rates were near zero, the value of a Eurodollar spiked to nearly 100. Going back to the year 2000, one can see that the value of a Eurodollar at this time was closer to 93, indicating that short-term yields at that time were closer to 7%.
At this point, we’ve established that Eurodollar prices are extremely sensitive to interest rate decisions by the Federal Reserve. We also know that the Eurodollar prices rallied recently, apparently because expectations for a rate cut by the Federal Reserve in the near-to-middle term increased significantly.
The graphic below highlights the market’s expectations for ongoing short-term rates, and one can clearly see in the data how the the market’s current bias indicates a declining interest rate environment:
While no model can perfectly predict when or if a recession may set in, the above data clearly shows that one (of the many) potential red flags for the economy has been triggered. Long-term rates dipped below short-term rates, which is traditionally called an “inversion” of the yield curve.
In history, each and every recent recession in the United States has been preceded by an inversion in the yield curve. Having said that, not every yield curve inversion has ultimately seen a recession follow it.
On the balance of Options Jive, the hosts review additional data related to the S&P 500 and Eurodollar. Using this information, a sample pairs trade is outlined which utilizes futures to access these two products. If you are looking to learn more about Eurodollars futures and potential trading structures that involve them, we highly suggest reviewing the complete episode of Options Jive when your schedule allows.
Likewise, we also recommend reviewing this previous installment of Options Jive (“Trading Short-Term Yields with Eurodollars”), which provides a comprehensive introduction to Eurodollars.
If you have any questions about trading interest rates, or any other niche of the financial markets, don’t hesitate to leave a message in the space below, or contact us directly @tastytrade (Twitter) or firstname.lastname@example.org (email).
We look forward to hearing from you!
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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