Hedge Your Interest Rate Risk with Straits Financial

Apr 26, 2018

Hedge Interest Rate Risk

During the past few weeks, investors have been increasingly worried about US treasury yields. In March, the Federal Open Market Committee (FOMC), a part of the Federal Reserve Bank, voted to raise US interest rates by a quarter of 1% and indicated there would be 2 or 3 more interest rate hikes this year based on their economic outlook. The March hike is the 6th rate increase since 2015. For traders, 3-4 rate hikes in just one year is a lot to process, and this has some investors concerned.

While the economic outlook was considered positive from the FOMC, some investors and traders are reluctant to agree because of rising levels of government debt and accelerating inflation seen in oil and commodity markets. Interest rates play a crucial role in all sectors of the economy: financing the US $20.2 trillion in Gross Federal Debt; servicing variable rate mortgages, floating-rate debt, short-term borrowing, annuities, and bond funds just to name a few. With so many areas of the economy linked to interest rates, even small increases can cause significant effects on the global economy. The FOMC are always in the unenviable position of maintaining growth without letting inflation gain a foothold. So their interest rate decisions are always a delicate balancing act. The board members do their best to gradually raise rates to maintain that perfect balance of growth vs. inflation. With the key interest rate presently at 1.75%, analysts predict it is very likely to be raised up to 2.25% by year’s end, and a 50% chance to be raised to 2.5% by the time the last of the six remaining FOMC meetings in 2018 have been conducted. Many feel these raises will be done gradually via a ¼ percent raise three times amongst the six remaining meetings.

There is developing speculation that shareholders could sell out of equity holdings and allocate to Treasuries as a more attractive investment in a rising interest rate environment. The past ten years have provided such steep returns in equities; investors could move en masse to bond markets to reevaluate equity markets in “safer” territory. This mass exodus of capital in US equity markets could have a significant snowball effect worldwide and substantially hurt companies that are caught underfunded.

The Yield Curve

The 10 year Treasury yield, a benchmark number used across the economy, is causing the most attention worldwide as it approaches a critical psychological level of 3%. Last week, the 10-year yield rose 2.5% up to 2.949%, the highest since January 2014 and the 2-year Treasury note reached 2.457%, it’s highest since August 2008.

The yield curve, which measures the rates of Treasuries across different durations, has been flatter lately, meaning short-term rates align more evenly with longer-term rates. During past market corrections, a flattening or inverted yield curve is indicative of an economic recession on the horizon. However, many traders are confident a steepening of the yield curve will occur, which makes longer-term rates move higher than short-term. This steepening effect would demonstrate strength in the economy and align with Federal Reserve expectations. If the reverse happens, and the yield curve inverts, that is when markets will likely see a correction, increased volatility, and possible rebalancing.

Mounting Global Pressures

Recent volatility and trade disagreements (The Risk of Tariffs to Midwest Farming) have caused unpredictability and great dis ease in the markets. Traders are questioning the actions the Federal Reserve may take if tariffs happen on a larger scale. With retail industry defaults in the US at historic levels, there seems to be a bleaker picture for the US economy. Furthermore, some gauges of long-term inflation hit their highest levels in 3.5 years this Monday - the U.S. 5-year inflation swap touched 2.5385% during European trading hours, the first time its traded at those levels since November 2014.

With a new Federal Reserve President at the helm, and rising amounts of debt, anticipation and volatility are creating a new narrative in the markets. The following are some key events that traders will be watching as the action in Treasuries unfolds:

Many fixed-income traders are eager to hear statements from European Central Bank (ECB) President Mario Draghi tonight regarding rate policy changes after he acknowledged a Eurozone slowdown last week at the International Monetary Fund (IMF) meetings. Bloomberg reports that investors mostly anticipate the first ECB rate hike in mid-2019. Also, traders are eager to tune in May 2nd for the Treasury Refunding Announcement, which will detail the U.S. Treasury funding needs for the next two quarters. Investors in the bond market pay close attention to this release to evaluate appropriate yields for trading U.S. Treasury products.

Hedge with Futures

With rising interest rates and unsettled markets, futures trading provides an opportunity for traders to protect capital and arbitrage between different treasury and equity futures products. By utilizing your account with Straits, you can gain access to global trading exchanges and take advantage of trading opportunities during all market environments.

Straits provides direct access to CME Group where Treasury futures products trade in all time zones. We also offer unique opportunities to customize strategies and arbitrage between products at exchanges. Please click here to view exchange access by platform.

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DISCLAIMER: This document is issued for information purposes only. This document is not intended, and should not under any circumstances to be construed as an offer or solicitation to buy or sell, nor financial advice or recommendation in relation to any capital market product. All the information contained herein is based on publicly available information and has been obtained from sources that Straits Financial believes to be reliable and correct at the time of publishing this document. Straits Financial will not be liable for any loss or damage of any kind (whether direct, indirect or consequential losses or other economic loss of any kind) suffered due to any omission, error, inaccuracy, incompleteness, or otherwise, any reliance on such information. Past performance or historical record of futures contracts, derivatives contracts, and commodities is not indicative of the future performance. The information in this document is subject to change without notice.  The impact on market prices due to seasonal or market cycles and current news events may already be reflected in market prices.