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BACK TO BASICS: The Impact of Interest Rate Changes
By Jeff Neal, Optionetics.com
3/14/2005 8:00 AM EST

http://optionetics.com/articles/article_full.asp?idNo=12068

Of all the futures contracts that are traded daily, the interest rate contracts are probably the most liquid and, to me, the most interesting. They are interesting because of the macro-economic information that can be determined from their movements. Whether you’re a futures trader, stock trader or an analyst trying to get a handle on a possible forecast, it is important to understand the supply and demand forces that propel these contracts.

In its most basic sense, interest rates are the price of investment funds. Low rates indicate that either supply is abundant or demand is weak. On the other hand, high rates imply that demand is robust in relation to supply.

To best illustrate this relationship let’s use long-term bonds. Supply is made up not only of bonds currently being issued, but also all past issued bonds, corporate and municipal, which can be interchangeable with one another. The demand side is made up primarily of financial institutions, pension funds and insurance funds in particular.

Interest rates on long-term U.S. government bonds represent a real return plus an inflation premium. The amount of that premium depends on expectations, which are influenced by actual experience over the previous few years, plus investors’ confidence in the resolve of the U.S. Federal Reserve System to battle or not battle inflation.

On the other hand, short-term interest rates are far more volatile and more complex. First look at a concept that plays an important part in bond pricing which is the yield curve. In a positive yield curve, the shortest-term maturities have the lowest yields. For a negative, or inverted yield curve, the highest yields are in the shortest maturities and the longer-term maturities have the lowest yields.

The yield curve can be equated to the market structure of other futures markets. The normal market or carrying charge market has the lowest prices in the nearest months, while an inverted market has the highest prices in the nearest months. Inverted commodity markets happen during periods when physical supplies are scarce, so negative yield curves occur when money is in short supply.

The Federal Reserve, through its open-market operations, can create periods of tight and easy money. Many economists doubt that the Fed can have much control over bond prices, but it can influence short-term rates greatly. The Federal Reserve will also go through periods when controlling interest rates is not its primary aim, and instead it tries to control the growth of the money supply, letting the market determine the appropriate rates. Thus one of the keys to successfully trading short-term interest-rate futures is to correctly forecast what the Fed will be attempting to do.

Except for situations where the Federal Reserve is intervening, short-term rates are a function of supply and demand. The supply consists from institutions plus individual savings; the demand, from government plus the private sector generally. The private sector is the swing component in credit demand.

When government deficits are high, rates will also tend to be high if there is any strength in the economy. Government credit demand is not responsive to high rates, but the private sector does respond. A prolonged period of high rates eventually brings on a recession and collapses private credit demand.

When developing a fundamental game plan to forecasting futures prices, it is important to have a view toward interest rates, the future road-map of the world economy, and the future strength or weakness of the U.S. dollar. An understanding of the fundamental economics is essential for trading in markets such as interest rates and currencies. In addition, the economic fundamentals revealed by interest rates can have a profound impact on the equity markets as well.

Happy Trading.


Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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