U.S. Treasury Bond Futures

Nobody owes more money than the United States government.  With trillions of dollars of debt to be financed, the U.S. Treasury Department routinely issues bills, notes and bonds to finance the federal government debt.  Many common U.S. government bils, notes and bonds are:

T-Bills  - U.S. Treasury Bills are short term debt obligations.  They mature in as little as 90 days.

Notes -  U.S. Treasury Notes are considered the medium-term debt obligations.  Typically, the Treasury issues Notes in  2-year, 5-year 10-year maturities.

Bonds – U.S. Treasury Bonds are the long-term debt obligations.  Generally, Bonds are issued in 30-year maturities.

To sell its debt obligations, the U.S. Treasury typically holds a quarterly auction.  The debt obligations are sold to investors, banks, financial institutions, etc. 

A Need To Hedge. As we all know, interest rates are constantly changing.  This change in interest rates creates uncertainty and financial risk for financial institutions.  Many years ago, it was determined that a mechanism must be created whereby financial institutions could “hedge” their interest-rate financial risk.  That led to the creation of financial futures – more specially, US Treasury Bond market futures. 

Simply defined, a Bond market futures contract is an agreement for the purchase or sale of a U.S. debt obligation (ie. T-Bill, 2-year note, 5-year note, 10-year note or 30-year Bond) at a specific date in the future.  Through the purchase or sale of futures contracts, financial institutions could transfer or “hedge” their interest rate risk.  Here’s an example of how it works:

Assume you need a $100,000 loan.  You go to the bank and they agree to loan you the money.  Although the bank allows you to “lock” your interest rate today, the loan itself will not actually “close” for another 30 days.  Assume the interest rate the bank will charge you is 5%.

Banks often get their money by borrowing it from the Federal Reserve.  The bank will not borrow the $100k from the Federal Reserve until it’s time for your loan to close.  Today, the interest rate the bank pays for the money is 3% (the bank pays 3% for the money and loans it to you for 5%, with the 2% difference being the bank’s profit). 

What if interest rates go up during the next 30 days?   If rates rise by 1% during that time, the bank’s profit will be cut in half.  That’s not good business for the bank.  What the bank needs is a way to “hedge” against rates rising for the next 30 days.  They do that in the U.S. Treasury Bond futures market. 

At the time you “lock” your interest rate, the bank uses this market to hedge its risk  (if your loan is a 30-year loan, the bank will use a 30-year bond futures contract for its hedge). Since the bank is worried about rates going up, it sells one futures contract to hedge the transaction. 

What’s the net result of the hedge?  Assume that rates in fact go up during the 30 days and the bank must pay 4% when it borrows the money from the Federal Reserve.  In this case, the bank lost 1% of profit on the loan.  However, since the bank hedged itself in the U.S. Treasury Bond futures market it will have earned an equivalent profit via the hedge.

What if rates go down during the 30 days and the bank only pays 2% when it borrows the $100k from the Federal Reserve.  In this case, the bank will earn an extra 1% profit on the loan.  However, the hedge in the U.S. Treasury Bond futures market will result in a loss on that part of the transaction. When taken together however, the extra 1% of loan profit and the loss on the hedged transaction will offset each other. 

By using the hedge, regardless of whether rates rise or fall, the bank has eliminated its risk from fluctuating interest rates. (from the time they agreed to issue your loan until the loan closed).

Enter The Speculator. For any futures market to be viable, there must be both buyers and sellers.  The U.S. Treasury Bond futures market cannot function unless someone is willing to take both sides of the transaction.  That role is filled by speculators.  By design, it’s the speculators who accept the risk that the hedgers seek to avoid. 

Every speculator or “trader” enters the markets in search of profits.  Just how successful a trader may be is a function of many things.  At Kesef Trading, our game-plan for trading begins with an ongoing assessment of the “fundamental” economic conditions.

The rise and fall of interest rates is linked to one thing – the condition of the U.S. economy.  It’s the job of the Federal Reserve to help keep the U.S. economy on the right track.  Generally, that means the economy should be growing at an acceptable pace, without much price inflation.  To help guide the economy, the Federal Reserve raises or lowers interest rates.  Lowering rates serves to stimulate the economy (leading to growth) and raising rates will slow the economy.

Like many others in the financial world, Kesef Trading continually examines economic reports to get a sense of where we believe interest rates may heading next (up or down).  While we follow these reports closely (you can read our weekly assessments of current economic activity by subscribing to our free newsletter, The Weekly Chronicles), we never place trades solely on the basis of this information.  Stated simply, our assessment of current economic events merely gives a “big picture” of where we believe Bond market prices may be going longer term.

To be more specific about our Government Bond Plus trading program........ Like people, each market has a distinct “personality”:  If you know an individual’s personality, over time, you gain an understanding of how that person is likely to react to certain types of events.  For example, if a husband brings flowers home to his wife, there may be a very high probability she’ll have a smile on here face.  Or, for example, if a teenager returns home two hours past their curfew there may be a very high probability that one if not both of their parents will be angry.  Thus, if a specific action occurs you can deduce (with a high degree of probability) that a specific reaction is likely to follow. At Kesef Trading, we apply this same approach with the markets we trade. 

By analyzing real-time market activity, we’ve identified and categorized numerous recurring action and reaction events within the price activity of the bond markets. We’ve determined how frequently each action has in fact been followed by the anticipated price reaction.  Those price events with the highest probability (the highest probability of the action leading to the anticipated price reaction) form the foundation of our trading program.

Each trading day, we monitor bond market price activity to see when “qualified” price actions occur.  When an action is identified, we then establish market positions in an attempt to profit from the anticipated price reaction.   Of course, there are times when price action fails to produce the expected reaction.  To minimize those times, we only include (in our trading program) those price events that have the highest probability.

Our Focus

As noted previously, there are several futures markets available in the U.S. Treasury bond market sector.  After conducting extensive research, we’ve chosen to center our focus on the longer term maturity futures – primarily the 30-year U.S. Treasury Bonds.  The reasons for this are two-fold:

1. The 30-year Treasury Bond futures offer more of the “high-probability” price events.  Although we’ve identified price events in all of the Bond futures markets, it’s the 30-year maturity that has the highest number of high-probability events.  Having more high-probability events leads to more high-probability trades and hopefully enhanced profitability for our program.

2. When dealing with Bonds, the longer the maturity the more price volatility you see.  Shorter-term Bonds tend to have restrictive price ranges.  That typically leads to less trading opportunity.  Trading in the 30-year bond provides us with the maximum amount of price movement and thus, offers greater opportunity.

To learn more about our trading program, click here.