Treasury Yield Curve: Federal Funds & Expectations

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Treasury Yield Curve: Federal Funds & Expectations
Š2009 OS Financial Trading System

FTS Treasury Yield Curve Case: Federal Funds Market Expectations and Changes in the Yield Curve Shape

The federal funds futures market embodies useful information about the market's expectation of future Federal Reserve Bank policy. Monetary policy is implemented by the Federal Reserve by making discrete adjustments to its target Federal Funds rate. This rate influences the opportunity cost of short (and longer) term Treasury Rates and therefore forecasting the timing and magnitude of Fed movements is a popular exercise. Factor analysis studies of the Treasury Yield Curve (see appendix of this write-up) reveal that most of the variation is explained by three factors. These factors loosely coincide with three basic movements - parallel shifts (i.e., approximately constant shifts in level of all yields), twists (i.e., opposing movements) in long versus short term rates (yield spreads), and curvature adjusting shifts among yields along the curve (e.g., middle rates move in one direction and short/long rates move in an opposite direction). This motivates the following type of question:

Question: By extracting information from the Federal Funds Futures markets (plus related sources) form a view that relates this information to a prediction about one or more of the common yield curve movements. Next design a short term trading strategy using the four constant maturity Treasury instruments. You should ensure that your strategy will make money if your view is correct and it may lose money if your view is incorrect. That is, consistency of your strategy with your view is the important objective of this exercise as opposed to whether or not your view turns out to be correct.

Tip: You are encouraged to use the FTS module (see appendix) to help you formulate your strategy.

Markets Open for Trading in the FTS RT Client: Constant Maturity Treasury/Federal Funds Case Federal Funds Futures Markets:

These markets trade interest rate futures contract. This is a futures contract whose value is derived from a fixed-income security contract yield. The underlying in this case the average daily effective federal funds rate implied from transactions for the delivery month. The final settlement price for a contract is 100 minus this average rate. In the FTS markets you can trade futures ranging approximately up to 2-years.

Constant Maturity 91-Day Treasury Bill: (FTS Ticker CMTB). The 91-day constant maturity Treasury Bill has a maturity that does not change when moving forward through time. The real time price is derived from the ticker IRX (3-month T-bill). Quotation is in T-bill form and the face value of 1 contract is $10,000.

Constant Maturity Treasury Notes (5-Year and 10-Year): (FTS Ticker CM5TN and CM10TN). These are 5-year and 10-year constant maturity Treasury Notes. Again the maturity of each note does not change as we move forward through time. Their prices are derived in real time from the ticker symbols FVX (5-year) and TNX (10-Year). Quotation is T-Note form (relative to 100 and in 32nds), coupon rate = 6% payable semi-annually and the face value of 1 contract is $10,000.

Constant Maturity Treasury Bond (30-Year): (FTS Ticker CM30TB). This is a 30-year constant maturity Treasury Bond whose real time price is derived from the ticker symbol TYX (30-year). Quotation is T-Bond form (relative to 100 and in 32nds), coupon rate = 6% semi annually and face value of 1 contract is $10,000. Š2009 OS Financial Trading System

FTS Interest Rate Risk Module Appendix:

Run the Interest Rate Risk Module from the FTS System Manager.

To run this application you will need to one time request a student Authentication code which you will receive automatically from your university email account once you request it.
Now you can launch the Interest Rate Risk Module, enter your code and the following screen appears:

We will work with monthly data so click on Get Data followed by Clean Data followed by clicking on Process Data (the three buttons above).

Aside: The default data is US Treasury Data but you can read in any country data via Excel if you want to analyze the behavior of other country yield curves.

Next Step: Click on the button above labeled "Curve Analysis" this will get you to the yield curve analysis screen. Finally click on the button "PCA" to conduct the factor analysis of the US yield curve. The above example conducts this analysis from January 1994 up until December 2008. If you want to focus on sub periods of time you merely change the Start/End date.

Interpretation: The above plots the factor weights (Y-Axis) by the set of constant maturity Treasury rates provided by the Federal Reserve Bank. These rates range from 0.25 (3-month T-Bill 1st instrument) to the 30-Year Treasury Bond (9th instrument). As a result, the x-axis displays this as 1 to 9. Factor 1 the top (yellow plot) corresponds to the approximate parallel shift. Note all factor loadings moving from 3-months to 30-years are positive. Factor 1 currently accounts for 82% of the US Yield Curve variance over the time period studied (this is the number above beside Proportion). Factor 2 (the red graph) reflects a yield curve twist. Observe this factor has negative weights for lower maturity yields and positive weights for longer maturity Treasuries. In other words the long and short ends move in opposite directions. This factor accounts for 14% of the variation. Finally, Factor 3 (the green graph) reflects the "curvature factor." This factor accounts for just over 2% of the variance and observe captures the effect when long and short ends move in one direction and the middle part of the curve moves in the opposite direction.