The Basics of Treasury Futures

Treasury futures are standardized futures contracts used to purchase US government notes and bonds for future delivery. When you acquire a treasury future, you are not obligated to take delivery unless you hold the futures contract through expiration. Only a hedger would do that. I’m assuming you are a speculator, not a hedger, that’s looking to make money on the rise and fall in the treasury futures contract price.

The US government borrows through the US Bond market to finance its maturing debt and expenditures. As of December 2016 there are over $19 trillion of US government bonds and notes outstanding, making it the largest, most liquid and safest (in terms of credit worthiness) market across the globe.

The US government borrows money by issuing fixed term notes and bonds that have yields determined by the prevailing interest rates in the market at the time of issuance. There are a range of fixed terms; notes include 2, 3, 5, 7 and 10 years, while bonds are greater than 10 years; such as 20, and 30 year bonds.

Treasury futures trade around the clock, which means there are constant price fluctuations, and therefore constant opportunities to trade for profit. The price goes up and down, generally inverse to the rise and fall of interest rates. So bondholders will witness their principal value decline and interest rates rise. In a declining rate market, bond prices will increase.

Each treasury future contract has a face value at maturity of $100,000, except for the 2 and 3 year notes, which have a value of $200,000 at maturity. This is also called the Big Point Value (BPV) of the future contract. Prices are quoted in points per $1000 for 5 through 30 year treasuries, and points per $2000 for 2 and 3 year contracts.

The minimum tick value varies per contract, with 2 and 10 year notes at $15.625 per tick, 5 year notes at $7.8125 per tick, and 30 year bonds at $31.25 per tick.

You can calculate the cash value of a futures contract by multiplying the current quoted price by the Big Point Value. This is important, because when we trade treasury futures, we only use the cash value, also called the notional value, of the contract on which to perform analysis. And when we trade them in pairs, we analyze the notional difference between the pairs.

So, for example, when we trade the 10 year note long versus the 30 year bond short, we calculate the notional difference in dollars with the following formula:

(10 yr price x $1,000) – (30 yr price x $1,000) = notional difference (USD)

Trading Treasury Futures

Treasuries are great barometers and predictors of the US and world economy’s strength or weakness. Historically, when the US economy strengthens, the yield on treasuries rises, and therefore, because of the inverse relationships, the futures price falls.

Rates rise for a number of reasons as an economy heats up. Fir example demand for loans increase, therefore the cost of those loans increases, which pushes interest rates higher. Also, when prices increase, there’s a risk of inflation going up, so the Federal reserve will adjust their monetary policy and try to combat this increase by raising short term lending rates, in an attempt to decrease demand by increasing the cost of lending.

Federal Reserve policy does not change with every whim of the market. It is like trying to turn a 1500 foot cruise liner, compared to a turn on a dime 15 foot speed boat. In other words, the direction or rate of change of interest rates by the Federal reserve occurs over several months to a few years, rather than reacting to every fluctuation in the market.

This makes the choices very clear for the trader, in terms of the prevailing direction they want to trade, either long or short. Traders would find it much less risky to go with the fed, rather than try to go against it. You’ve probably heard the saying, don’t fight the Fed.

Trading the Yield Curve

The yield curve is the plot of current interest rates across all the treasury maturities, from short to long term. In a healthy economy, the curve that this plot creates is generally steep, so short term yields are low, while longer term yields are higher. And historically an improving economy is one that has a steepening yield curve, while a weakening economy is one that has a flattening one.

This is the trade we do here at Upland Asset Management LLC, and what I teach in the Notes Over Bonds training. It’s a pairs trade, so that we can take advantage of the changing slope of the yield curve by simultaneously trading a shorter maturity and longer maturity treasury futures contract. In our case that’s the 10 year note versus the 30 year bond.

When the yield curve is steepening, the 30 year yield will rise faster than the 10 year yield, And because futures prices are inverse to yield, that would mean we trade the 10 year long and the 30 year short. But we only trade it when there’s a temporary disruption in the market, which will throw off the normal correlation between the pair. Disruptions can be caused by any number of occurrences, but mostly from unexpected economic reports, foreign exchange fluctuations, global price shocks and treasury auctions.

Our ability to get on these trades is highly reliable, and we exit them with a better than 80 percent win rate, along with a very high return on capital, averaging 50 percent return on capital, and with 100-150 percent returns not uncommon at all.

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