Interest Rates 101- Series 4

June 23, 2014 12:20PM CDT

If you missed Interest Rates 101 Series 12, or 3 – please click the respective links.

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.

Demand Phenomenon - Inflation

If we assume that borrowers of U.S. debt expect a given real return, then an increase in expected inflation will increase the normal interest rate (the nominal yield = real yield + inflation). Inflation also explains why short-term rates move more rapidly than long-term rates. When the Fed raises short-term rates, long-term rates should increase to reflect the expectation of higher future short-term rates; however, this increase is mitigated by lower inflation expectations as higher short-term rates also should predict lower inflation (as the Fed sells/supplies more short-term Treasuries, it collects money, and “tightens” the money supply).

Fundamental Economics

The factors that create demand for Treasuries include economic growth, competitive currencies, and hedging opportunities. Just remember: anything that increases the demand for long-term Treasury bonds puts downward pressure on interest rates (higher demand = higher price = lower yield or interest rates) and less demand for bonds tends to put upward pressure on interest rates. A stronger U.S. economy tends to make corporate (private) debt more attractive than government debt, decreasing demand for U.S. debt and raising rates. A weaker economy, on the other hand, promotes a “flight to quality,” increasing the demand for Treasuries, which creates lower yields. It is sometimes assumed that a strong economy will automatically prompt the Fed to raise short-term rates, but not necessarily. Only when growth translates or “overheats” into higher prices is the Fed likely to raise rates.

Conclusion for Series 1, 2, 3, and 4

We have covered some of the key traditional factors associated with interest rate movements. On the supply side, monetary policy determines how much government debt and money are supplied into the economy. On the demand side, inflation expectations are the key factor. However, we have also discussed other important influences on interest rates, including: fiscal policy (that is, how much does the government need to borrow?) and other demand-related factors such as economic growth and competitive currencies. We've suggested these other factors are constantly shifting, but two important questions to ask are: “Does fiscal policy create too much supply?” and “Will the demand for U.S. denominated debt keep pace in the global market?”

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.

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