10-Year T-Note vs. 10-Year Yield Futures: Which One To Trade?Introduction:
The 10-Year T-Note Futures and 10-Year Yield Futures are two prominent instruments in the financial markets, offering traders unique opportunities to capitalize on interest rate movements. This video compares these two products, focusing on their key characteristics, liquidity, and the differences in point and tick values, ultimately helping you decide which one to trade.
Key Characteristics:
10-Year T-Note Futures represent a contract based on the value of U.S. Treasury notes with a 10-year maturity, while 10-Year Yield Futures are based on the yield of these notes. The T-Note Futures contract size is $100,000, while the 10-Year Yield Futures contract size is based on $1,000 per index point, reflecting a $10 DV01 (dollar value of a one basis point move).
Liquidity Comparison:
Both 10-Year T-Note Futures and 10-Year Yield Futures are highly liquid, with substantial daily trading volumes and open interest. This high liquidity ensures tight spreads and efficient trade execution, providing traders with confidence in entering and exiting positions in both markets.
Point and Tick Values:
Understanding the point and tick values is crucial for effective trading. For 10-Year T-Note Futures, each tick is 1/32nd of a point, worth $31.25 per contract. The 10-Year Yield Futures have a tick value of 0.001 percent, worth $1.00 per contract. These values influence trading costs and profit potential differently and are essential for precise strategy formulation.
Margin Information:
The initial margin requirement for 10-Year T-Note Futures typically ranges around $1,500 per contract, while the maintenance margin is slightly lower. For 10-Year Yield Futures, the initial margin is approximately $500 per contract, reflecting its lower notional value and DV01. Maintenance margins for yield futures are also marginally lower, providing traders with flexible capital management options.
Trade Execution:
We demonstrate planning and placing a bracket order for both products. Using TradingView charts, we set up entry and exit points, showcasing how the different tick values and liquidity levels impact trade execution and potential outcomes.
Risk Management:
Effective risk management is vital when trading futures. Utilizing stop-loss orders and hedging techniques can mitigate potential losses. Avoiding undefined risk exposure and ensuring precise entries and exits help maintain a balanced risk-reward ratio, which is essential for long-term trading success.
Conclusion:
Both 10-Year T-Note Futures and 10-Year Yield Futures offer unique advantages. The choice depends on your trading strategy, risk tolerance, and market outlook. Watch the full video for a detailed analysis and insights on leveraging these products in your trading endeavors.
When charting futures, the data provided could be delayed. Traders working with the ticker symbols discussed in this idea may prefer to use CME Group real-time data plan on TradingView: www.tradingview.com This consideration is particularly important for shorter-term traders, whereas it may be less critical for those focused on longer-term trading strategies.
General Disclaimer:
The trade ideas presented herein are solely for illustrative purposes forming a part of a case study intended to demonstrate key principles in risk management within the context of the specific market scenarios discussed. These ideas are not to be interpreted as investment recommendations or financial advice. They do not endorse or promote any specific trading strategies, financial products, or services. The information provided is based on data believed to be reliable; however, its accuracy or completeness cannot be guaranteed. Trading in financial markets involves risks, including the potential loss of principal. Each individual should conduct their own research and consult with professional financial advisors before making any investment decisions. The author or publisher of this content bears no responsibility for any actions taken based on the information provided or for any resultant financial or other losses.
Treasuryfutures
Harnessing Gains from Yield Curve NormalisationNot too long ago, watching interest rates was as boring as looking at wet paint dry. Not anymore. Interest rates and currencies are as interesting as they get. The US dollar has been clocking moves more akin to an EM currency.
The greenback has been on a rollercoaster ride over the past three months in line with market expectations of Fed’s interest rate policy path. This paper is set in three parts. First, the background to rising rates and spiking yields leads to a brutal bond sell off. Then, the paper evaluates the case for further Fed rate hikes. In the third and final part, it dwells into factors that support a rate pause.
It is not just the rates but also the term structure of rates that’s gone off-the-chart. This paper posits a hypothetical spread trade inspired by the divergence in 30Y and 10Y treasuries with an entry at 13 bps and a target at 40 bps hedged by a stop at 5 bps delivering a reward-to-risk of 1.5x.
RISING RATES AND SPIKING YIELDS
Fed’s commitment to taming inflation with a higher-for-longer stance leads to a surging dollar. Spiking bond yields help reign in inflation through tightening monetary conditions.
The US 10Y Treasury Bond Yields surged to their highest level since 2007, by 20% or 0.8 percentage points since July 17th.
Chart 1: US 10Y and US 2Y Treasury Yields
Yield and Bond prices are inversely related. Surging yields have hammered bond prices lower resulting in a staggering record sell-off. Leveraged funds hold a record net short positioning in US 2-year and 10-year Treasury Futures.
Chart 2: Record Net Short Positioning by Leverage Funds
This brutal selloff has pushed yields to their highest levels in more than 15 years. Among others, portfolio managers and traders can position themselves one of the two ways:
Risk Hedged Yield Harvesting: Harvest risk hedged treasury yield using cash treasury positions and Treasury futures to generate income over a long horizon, or,
Gain from Yield Curve Normalisation: Deploy CME Micro Treasury Futures to engineer a spread trade to realise gains from a normalising yield curve.
In a previous paper , Mint Finance illustrated the first. Distinctly, this paper covers spread trade using CME Micro Treasury Futures.
THE CASE FOR HIKING
The September FOMC meeting re-affirmed a higher-for-longer rate regime. Though there was no rate hike, the updated Fed’s dot plot signalled very different expectations for the rates ahead.
The dot plot was updated to show a final rate hike in 2023 and fewer rate cuts in 2024.
Chart 3: Contrasting US Fed’s Dot Plot between 14/June versus 20/September ( Federal Reserve )
The Fed has adequate grounds to crank up rates even more as highlighted in a previous paper . These include (a) American exceptionalism where the US Economy has been remarkably resilient, (b) Expensive Oil due to geopolitics & receding base level effects, and (c) Brutal Lessons from past on the folly of premature easing.
THE CASE FOR PAUSE
Factors described above have led markets to price another rate hike at Fed meetings later this year. Those views have started to tilt further towards a pause since the start of October as per CME FedWatch tool.
Chart 4: Target Rate Probabilities For 13/Dec Fed Meeting ( CME FedWatch Tool )
Bond yields have surged, helping the Fed with their fight against inflation. Yields on US Treasuries surged to their highest since 2007. As yields are inversely proportional to bond prices, this is the equivalent of a major selloff in the bond market.
Three reasons behind the selloff:
1. Steepening Yield Curve:
Yields are finally catching up to market rates, especially for long-term treasuries; yield curve is steepening
Chart 5: Yield Curve is Steepening
2. Rising Sovereign Risk Premia: The US national debt passed USD 33 trillion and is set to reach USD 52 trillion within the next 10 years. Investors are demanding higher risk premia as compensation for default risk by a heavy borrower.
Chart 6: US Debt to GDP Ratio
3. Higher Yield to Compensate for Scorching Inflation: Investors are demanding higher real rates amid a high-inflation environment.
Chart 7: Real Yields are marginally above zero
Bond yields seem to be peaking. Solita Marcelli of UBS Global Wealth Management opines that the recent upward momentum in yields has been spurred largely by technical factors and is likely to be reversed given the overhang of uncertainty over underlying forces guiding the Treasury market.
Higher bond yields support a case for a Fed pause. This is because rising treasury yields do part of the Fed’s job. Higher treasury yields tighten financial conditions in addition to being a drag on the economy.
The Fed officials shared similar sentiments over the past week:
San Francisco Fed President Daly noted the moves in markets “could be equivalent to another rate hike”.
The Atlanta Fed chief opined that he doesn’t see the need for any more rate hikes.
The Dallas Fed President remarked that such a surge in bond markets may mean less need for additional rate increases.
The Fed has made it amply clear many times that it is data dependent. The data about the economy is positive. And that is concerning. Jobs data last week, and a sticky CPI print raise concerns that the Fed’s hand might be forced to hike despite US inflation being low among G7.
Chart 8: US Inflation is among the lowest within G7s
HYPOTHETICAL TRADE SETUP
Are we witnessing peak rates? In anticipation of the peak, investors can use CME Micro Treasury Futures to harness gains in a margin efficient manner. Micro Treasury Futures are intuitive as they are quoted in yields and are fully cash settled. They are settled daily to BrokerTec US Treasury benchmarks for price integrity and consistency.
As highlighted in a previous paper , each basis point change in yield represents a USD 10 change in notional value across all tenors, making spread trading seamless.
Setting up a position on yield inversion between 2Y and 10Y Treasuries is exposed to significant downside risks from near-term rate uncertainty.
Instead, a prudent alternative is for investors to establish a spread with a short position in 10Y rates and a long position in 30Y rates. The 30Y treasury rates demand a higher term premium due to their longer maturity.
Presently, this premium is just 0.15%. In the past, this premium has reached as high as 1% during periods of monetary policy shifts with yield curve steepening.
Chart 9: US Treasury Inverted Spreads
Furthermore, downside on this spread is limited as the 30Y-10Y premium scarcely falls below 0% unlike the 10Y-2Y premium which has been in deep inversion for the past year. A long position in 30Y Treasury and a short position in 10Y Treasury with:
Entry: 0.130 (13 basis points)
Target: 0.4 (40 basis points)
Stop Loss: -0.05 (5 basis points)
Profit at Target: USD 270 (27 basis points x USD 10)
Loss at Stop: USD 180 (18 basis points x USD 10)
Reward to Risk: 1.5x
Chart 10: Hypothetical Spread (Long 30Y & Short 10Y) Trade Set Up
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Harvesting Risk Hedged Treasury YieldEver heard of risk-free rates? Risk free rates are commonly understood to refer to interest rates on 10-year US treasuries. These are considered risk-free as the likelihood of the US government defaulting is considered extremely unlikely.
Treasuries pay out a fixed interest and can be redeemed for their face value at maturity. Fixed returns and negligible default risk make treasuries a critical addition to any decent investment portfolio.
With inflation on the downtrend and Fed’s hiking cycle nearing its apex, long term treasuries provide a fixed income-generating asset with no reinvestment risk.
Little default risk does not mean zero market risk. As highlighted in our previous paper , bond prices are materially exposed to interest rate risk. CME Group’s treasury futures allow investors to hedge that risk.
This paper has been split into two parts – the first provides an overview of treasury futures and their nuances while the second walks through the trade setup required to harness risk-hedged yield.
TREASURY FUTURES
Treasury futures enable investors to express views on a bond’s future price movement. Investors can also hedge against interest rate risk by locking in a coupon rate. CME treasury futures are deliverable with eligible treasury securities which ensures price integrity.
QUOTING
Treasuries are quoted in fractional notation as a percent of their par value. For instance, a bond quoted at 111’272 suggests that it is trading 11 + 27.2/32 (11.85%) above its par value. This allows standardized quotation of bonds with different coupon rates.
Note that notion of quotes in cash markets may be different from futures.
AUCTION SCHEDULE
Treasuries are auctioned periodically depending on their maturity duration.
• Treasury Bills with maturity between 4 to 26 weeks are auctioned every week while T-Bills with maturity of 1-year are auctioned every four weeks.
• Treasury Notes with maturity of 2, 3, 5, and 7 years are auctioned every month while T-Notes with maturity of 10-years are auctioned every quarter.
• Treasury Bonds are auctioned every quarter.
The auctions for each type of security are staggered to reduce their market impact.
CONVERSION FACTOR
It is possible for a large range of “eligible” treasuries to be available for deliveries against standardised futures contract as new treasuries are regularly auctioned at changing rates. The most recently auctioned securities that are eligible for delivery are called “on the run” securities.
To standardize the delivery process for varying securities, a conversion factor unique to each bond is used. The buyer of the futures contract would pay the Principal Invoice Price to the seller. The Principal Invoice Price is the “Clean Price” of the security and is calculated by applying the Conversion Factor to the settlement price.
When the Conversion Factor is less than 1, the buyer pays less than the settlement price and when it is higher than 1 the buyer pays more.
ACCRUED INTEREST
In addition to the adjustment for the quality of the bond being delivered, the buyer must also compensate the seller for any interest the bond would accrue between the last payment and the settlement date.
The final cost to deliver the treasury futures contract would be the Clean Price + Accrued Interest.
CHEAPEST TO DELIVER
Due to the Conversion Factor, which is unique to each bond, some bonds appear to stand out as cheaper alternative for the seller to deliver. So, if a seller has multiple treasury securities, a rational seller will choose to deliver the one that best optimizes the Principal Invoice Price.
As a result, futures price most closely tracks the Cheapest-to-Deliver ("CTD”) securities.
This also provides an arbitrage opportunity for basis traders. In this case, the basis is the relationship between the cash price of the security and its clean price on the futures market. Small discrepancies in these may be profited upon.
Notably, specialized contracts such as CME Ultra 10-year Treasury Note futures with selective eligibility requirements diminish the effects of CTD by reducing the range of deliverable treasuries.
HEDGING BOND PRICE RISK WITH TREASURY FUTURES
Treasury securities are a crucial and substantial addition to any well diversified portfolio, offering income generation, diversification, and safety.
With interest rates elevated and inflation heading lower, coupon rates for long-term US treasuries are yielding positive real returns. Moreover, 10Y yield is hovering at its highest level in 13-years suggesting a strong entry point.
Since the coupon rate of the security is fixed and they can be redeemed at face value upon maturity, the present higher yielding treasuries are a great long-term income generating investment.
Despite the inverted yield curve, which suggests yields on longer-term securities are lower, a position in long-term bonds protects against reinvestment risk. Reinvestment risk refers to the risk that when the bond matures, rates may be lower.
With Fed at the apex of its hiking cycle, rates will likely not go any higher. So, a position in long term T-bond, locked in at the current decade-high rates, offers a lucrative opportunity. The position also benefits in the uncertain scenario of a recession as bond prices rise during recessions.
This investment fundamentally represents a long treasury bond position which profits in two ways: (a) Rising bond prices when interest rates decline, and (b) Coupon payments.
If the coupon payout is unimportant, fluctuations in the bond price can be profited upon in a margin efficient manner using CME futures. This does not require owning treasuries as the majority of the treasury futures are cash settled with just 5% reaching delivery.
In the fixed income case, the bond is held until maturity which leads to opportunity costs from bond price fluctuations.
CME futures can be used to harvest a fixed yield from treasuries and remain agnostic to rate changes, by hedging the long treasury position with a short treasury futures position.
This position is directionally neutral as losses on one of the legs are offset by profits on the other. The payoff can be improved by entering the short leg after bond prices are higher.
To hedge treasury exposure using CME futures the Basis Point Value (BPV) needs to be calculated. BPV, also known as DV01, measures the dollar value of a one basis point (0.01%) change in bond yield. BPV depends upon the bond’s yield to maturity, coupon rate, credit rating and face value.
Notably, BPV for longer maturity bonds is higher as their future cashflows are affected more by changes in yield.
Another commonly used term is modified duration which determines the changes in a bond’s duration or price basis of a 1% change in yield. Importantly, the modified duration of the bond is lower than 100 BPV’s since the bond price relationship to yield is non-linear.
BPV can be calculated by averaging the absolute change in the bond’s yield-to-maturity, its value when held until maturity, from a 0.01% increase and decrease in yield. Where there are multiple bonds in a portfolio, the BPV for a unit exposure will have to be multiplied by the number of units.
On the futures side, BPV can be calculated as the BPV of the cheapest to deliver security for that contract divided by its conversion factor.
By matching the BPV’s on both legs, the hedge ratio can be calculated. This represents the number of contracts needed to entirely hedge the cash position.
SUMMARY OVERVIEW OF CME TREASURY FUTURES
CME suite of treasury futures allow investors to gain exposure to treasury securities across a range of expiries in a deeply liquid market.
Each futures contract provides exposure to face value of USD 100,000.
The 2-Year, 5-Year, and 10-Year contract are particularly liquid.
Micro Treasury Futures are more intuitive as they are quoted in yields and are cash settled. Each basis point change in yield represents a USD 10 change in notional value.
These products reference yields of on-the-run treasuries and settled daily to BrokerTec US Treasury benchmarks ensuring price integrity and consistency.
Micro Treasury Futures are available for 2Y, 5Y, 10Y, and 30Y maturities enabling traders to take positions across the yield curve with low margin requirements.
TRADE SETUP TO HARVEST RISK HEDGED TREASURY YIELDS
A long position in the on-the-run 10Y treasury notes and a short position in CME Ultra 10Y futures allows investors to benefit from the treasury bond’s high coupon payment while remaining hedged against interest rate risk.
Hedge ratios can be calculated using analytical information from CME’s Treasury Analytics Tool to obtain the BPV of each of the legs:
The on-the-run treasury pays a coupon rate of 3.375% pa. and its last quoted cash price was USD 98.04. It has a DV01 of USD 76.8.
Since, each contract of CME Treasury Futures represents face value of USD 100,000, the long-treasury position would need to be in multiples of USD 100,000.
For a face value of USD 500,000 (USD 100,000 x 5) this represents a notional value of USD 490,000 (Face Value x Cash Price) .
The long-treasury position's DV01 = USD 76.8 x 5 = USD 385.
The cheapest-to-deliver security has a DV01 of USD 92.2 and a conversion factor of 0.8244.
The futures leg thus has a BPV = Cash DV01/Conversion Factor = USD 92.2/0.8244 = USD 111.8.
The hedge ratio = BPV of Long Treasury/BPV of Short Futures = USD 385/USD 111 = ~4 (3.4)
So, four (4) lots of futures would be required to hedge the cash position which would require a margin of USD 2,800 x 4 = USD 11,200.
Though the notional on the two legs does not match, the position is hedged against interest rate risk and pays out 3.375% per annum in coupon payments.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
