On Jan. 21, 2019, we showed the inverted yield curve, with short-term interest rates higher than long-term rates through approximately the first two years of maturities. An inverted yield curve is not normal, often a harbinger of an economic downturn or outright recession and is usually a short-term phenomenon. Knowing these details, how can a trader take advantage of declining short-term rates?
The inversion of interest rates is in part due to Federal Reserve policy, since the Fed announced several times in 2018 that rate increases were planned. The usual area of interest rates for Fed activity is the short end as they main tool (outside of QE and operation twist) is the overnight Fed Funds rate. So the curve in the three-month Eurodollar futures needs to be watched.
Now that there are murmurs of potential economic slowdowns in 2019 and 2020, a real possibility exists for a decline in short-term rates. The Fed might be back in action – this time reducing rates instead of raising them.
Three-month Eurodollar Interest Rate futures are good bets for profiting from changes in short-term interest rates. Based on an imaginary base of a deposit of $1 million in a foreign bank, there are 40 quarterly futures contracts traded. A quarterly rate on $1 million deposit makes a change of one basis point (one hundredth of one percent) worth $25. Thus, a 1% decline in a short-term rate would provide a profit of $2,500 on a long position in a single Eurodollar futures contract.
The two charts showing Eurodollar futures rates and yields (from March 6, 2019, and Sept. 18, 2017) illustrate price changes as short term rates increased.
“Eurodollar Rate changes” (below) shows all losses on the 2017 futures up to March 6, 2019. The changes in rates extend from 0.88 % to 22.5 %. Of course, we want to avoid losses that would happen if we took long positions and the Fed decided to raise rates again. Perhaps it is best to wait until the need for lower rates is apparent, or the Fed announces a policy of reducing short-term rates.
Because of the short-term nature of an inverted yield curve in addition to factors in the economic world today (trade problems for example), lower interest rates may come sooner than later, and Eurodollar futures are made-to-order for exploiting short-term interest rate moves.