Interest Rates 101 - Series 1

March 24, 2014 1:08PM CDT

Most investors and traders care about future interest rates, but none more than future traders of stock index futures, interest rate futures, and currency futures. If you are considering a trade in any of these markets, you must ask yourself, “Do I think interest rates will rise in the future?” If the answer is “yes” then you probably want to avoid being long interest rate futures, or have some information between prevailing interest rates and yield duration (maturity) from short-term to long-term maturity rates.

The Treasury Yield Curve
In the United States, the Treasury yield curve is the first mover of all domestic interest rates and an influential factor in setting global rates. Interest rates on all other domestic bond categories rise and fall with U.S. Treasury, which are the debt securities issued by the U.S. government. To attract investors or traders, any bond or debt security that contains greater risk than that of a similar Treasury bond must offer a higher yield. For example, the 30-year mortgage rate historically runs 1% to 2% above the yield on 30-year Treasury bonds.

Consider three elements of this curve. First, it shows nominal interest rates. Inflation will erode the value of future coupon dollars and principal repayments; the real interest rate is the return after deducting inflation. The curve therefore combines anticipated inflation and real interest rates. Second, the FOMC directly manipulates only the short-term interest rate at the very start of the curve. The Fed has three policy tools, but their biggest hammer is the Federal Funds Rate which is only a one-day, overnight rate. Third, the rest of the curve is determined by supply and demand in an auction process. The FOMC directly manipulates supply and demand by their bond buying program in the last three years or to the tune of 3 trillion dollars.

In the upcoming series I will be looking at long rates versus short rates, and the supply/demand phenomenon. In the last part of this series, I will be looking at fiscal policy, and demand related factors

There have been entire volumes of textbooks written on interest rates, this report just scratches the surface. Futures trading is one of those fields where everyone has a different theory on what works and what doesn't. If we can leave you with one last tip, it is to back test whatever strategy you decide to pursue. Back testing means looking back at several years' worth of charts to see how a particular futures contract reacts. Different futures markets do different things, so be sure to do your homework first. If you are new to the futures markets and don't have a solid understanding of these markets, I recommend you contact me.

Interest Rates 101 Series 2

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