You may be wondering why mortgage rates haven’t gone down and have even fluctuated higher even though the Fed has been aggressively cutting interest rates over the last several months. When interest rates are flat, the interest rates on different maturities in Treasuries are relatively close, and when they become steep, it results in a more normal interest rate curve. The yield curve is simply a graphical comparison of the different types of interest rate instruments, from short-term to long-term. Let’s see how this all relates to futures markets, and how you can trade these concepts.

At the short end of the curve, the Fed funds rate is the overnight lending rate that banks charge when they borrow from each other to meet certain lending requirements, and the Fed has been cutting this rate in a series of moves since 2007. It currently stands at 2.25 percent.

The Federal Reserve requires that banks have a minimum amount of cash reserves on hand each day. If that amount falls below this requirement, the lending ability of banks becomes restricted, resulting in "tighter credit." The Federal Reserve has been trying to "inject liquidity" into the market by cutting the Fed funds rate to free up cash. Other tools such Term Auction Facilities (TAFs) and Term Securities Lending Facilities (TSLs) have also been introduced to the system to accommodate liquidity.

The misconception is that when the Federal Reserve cuts interest rates, it should result in lower mortgage rates. It is not necessarily true that mortgage rates would fall during this easing phase because mortgage rates are relative to the long end of the curve, i.e., the 30-year Treasury bond or the 10-year Treasury note. Usually, maturities at the long end of the curve are sensitive to monetary policy and inflation. Usually, maturities at the short end of the curve (Fed funds, maturities of less than one year and the two and five-year Treasury notes) are more sensitive to interest rate policy. However, the tumultuous banking environment over the past several months threw several other "curves" to the yield curve.

A "normal" yield curve would have a rising trend, where yields move up as we go out along a timeline from short-term to long-term instruments. Uncertainty had money chasing safety in Treasury instruments, which distorted yields across the board. Most of the safety was parked in short-term paper. When the safety play began to subside a couple of weeks ago and investors were more willing to venture into riskier assets, we saw rates on the two-year Treasury note quickly jump, approximately 20 basis points. This caused the yield curve to flatten, because the bulk of the safety play began coming out of the shorter maturities. If risk-aversion continues to subside (or if the S&Ps close above 1400), the longer maturities may follow and an increase in yields (decrease in prices) could out-pace the shorter end when the big money decides the safety game is over. The price bubble in longer-term Treasuries could deflate rapidly after most of the flight from safety is done on the short maturities.

The next catalyst could occur when the Federal Open Market Committee meets on April 29-30. The Federal Reserve is expected to cut the Fed funds rate by 25 basis points, with a chance of doing nothing at all. The market is anticipating that this may be the end of the easing cycle, with a provision of providing other mechanisms to keep liquidity in the banking system.

Trading Strategies

The markets will probably focus on the Federal Reserve pausing, at least until the meeting actually takes place on April 30. Expect position squaring and over the short term, I would sell rallies in any of the Treasury markets.

On the day of the FOMC meeting, you should probably wait to see what actually takes place to see if there are any surprises. Let the markets react with the initial knee-jerk price movement. Markets typically act one way on the day of the meeting, and do the opposite on the following day.

There are a variety of ways to play the yield curve. A simple way to trade the yield curve is to use options. For curve steepeners, you can buy calls in shorter maturities and buy puts in longer maturities. For flatteners, buy calls in the long-end and buy puts on the short-end.

You can also spread trade between different maturities. When you look at where interest rates are trading compared to what the Treasury futures are doing, it may look confusing at first glance. The Treasury futures are "weighted" to achieve the actual interest rates that you see posted in the cash market. Below are the "tick" equivalents in the Treasury futures, which correspond to a one basis-point change in cash interest rates:

2–Year Note – 1.18
5–Year Note &ndash 0.62
10–Year Note &ndash 0.35
30–Year Bond &ndash 0.2

Below are a few ratios which are theoretically neutral based on the change of the yield curve. (June 2008 contracts)

Two–year notes vs. 10–year notes = Long 100 TUM8 / Short 56 TYM8

10–year notes vs. 30–year bonds = Long 166 TYM8 / Short 100 USM8.

Five-year notes v. 30–year bonds = Long 100 FVM8 / Short 37 USM8.

To break it down into smaller trading size, you have to round off each equation by using 2-to-1, 3-to-1, or 4-to-1 ratios since there are no fractions of a contract.

This of course moves away from being neutral, but I assume your intention is to try to capture a gain if the yield curve goes your way. You can also make modifications depending on how conservative or aggressive your trading style is, or how bullish or bearish you want your strategy to be.

Take note that the five, 10 and 30-year contracts are $100,000 contracts:

One Basis Point = $31.25

The two-year note is a $200,000 contract:

One Basis Point = $62.50

All Treasury futures are based on price of the notes or bonds.

The following charts are examples of how you may want to play a curve steepener, also known as "buying the spread." To bet on a curve flattener you would do the opposite and you would be "selling the spread":

Long one TYM8 / short one USM8 (Anticipating that the 30-year price will decrease/ yield will appreciate faster than the 10–year)

Long one TYM8 / Short two USM8 (Same as above, but more aggressive in nature)

Long one TUM8 / Short two TYM8 

If you would like to get updates, discuss this further or, if you have any questions, please feel free to call me.

Carol Hurley is a Senior Market Strategist with Lind Plus, Lind-Waldock's broker-assisted division. She can be reached at 866-790-4371 or via email at churley@lind-waldock.com.

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