Bonds Analysis by Michael Ashton covering: US Dollar Index Futures, United States 2-Year, United States 5-Year, United States 10-Year. Read Michael Ashton's latest article on Investing.com
one of the effects of higher interest rates is that leveraged return strategies get swiftly worse as rates rise. Today, I want to talk about another result of higher interest rates which is, to me, much more fun and exciting. It involves the Treasury Bond cash-futures basis.so interesting. For many years, it hasn’t been.
Because the conversion factor is fixed, but the bonds all have different durations, which bond is cheapest-to-deliver changes as interest rates change. When interest rates fall, short-duration bonds rise in price more slowly than long-duration bonds and so they get relatively cheaper and tend to become CTD.
This situation persisted for decades. The last time the bond and 10-year note yielded as much as 6% was 2000. Can you predict approximately when the bonds will switch? Sure, because we know the bonds’ durations we can estimate the CTD – and the value of switching – for normal yield curve shifts. While the steepening and flattening of the deliverable curve also matter, remember that anything that adds volatility to the potential switch point adds value to you, the futures short. Here is, roughly, the expected basis at delivery of that Feb41 bond.
This all sounds, I’m sure, very “inside baseball.” And it is, because most of the people who used to trade this stuff and understood it are retired, have moved to corner offices, or are old inflation guys who just wonder why we don’t have a deliverable TIPS contract. But just as with my article two weeks ago, it’s something that I think is important to point out.
I am abstracting here from the more technical nuances of how one weighs a bond basis trade, again for brevity and accessibility.
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