Hola from Mexico City! It seems that the markets are interconnected to a greater degree than ever before – last week's article on the Dow/ Japanese Yen trade is just one example of this phenomenon. With that in mind, I have a great question from a reader this week regarding another important relationship - the impact of the buying and selling of U.S. Treasuries on the Forex market. Here it is!
Q) Hi Ed, I follow your work and it's provided some very good insight. I have a two-part question. With all the short term volatility we're seeing, I read that the TED spread is one of many good barometers for this. In order to gauge the next stage in the cycle should we be looking at the 2 year or 10 year Treasury to gauge what's coming 6 months to a year from now? Also, how are the Treasury yields interpreted? Thanks for your response.
Ed Ponsi) Thank you for your question, I'll take part two of the question first. When it comes to interpreting Treasury yields, there is an inverse relationship between price and yield. In other words, when the price of the bond rises, that bond's yield falls. For example, let's say that you purchased a new bond with a yield of 4% at a price of 100, also known as "par". Let's assume that a year passes, interest rates rise, and new bonds come available that yield 5% at par. Well, assuming that the safety and the maturity date of the bonds are similar, the 4% bond is no longer as attractive as the 5% bond. You can't sell the 4% bond for 100, because bond buyers will simply opt to purchase the higher-yielding 5% bond at the same price. So, you must sell the bond at a discount price. To the new purchaser, his return on the 4% bond is actually closer to 5%, because when it matures, the bond he purchased at a discount (less than 100) will be worth 100. This makes up for the fact that the bond yields only 4%.
The recent fear that has gripped global markets is reflected in all maturities of U.S. Treasuries, but especially on the short end, for example the 3-month Treasury bill. Why is so much of the action contained in the near-term maturities? Imagine that you are a hedge fund manager, and you want to protect your clients. You simply want to get out of the markets and stash that cash in a safe place. You start buying 3-month Treasuries (T-Bills), because no matter what happens, you are going to get all of your money back at par within three months. Fund managers, investment bankers, and other investors, both individual and institutional, have been piling into T-Bills at an incredible rate – they have been buying, which drives the price higher and the yield lower. Here is a chart of the yield of a three-month T-Bill (see figure 1).
Figure 1: The yield on 3-month T-Bills craters in mid-October. Source: theFinancials.com
Last week, the yield on 3-month T-Bills dropped to virtually nothing. Investors were scooping them up anyway, because in a risky environment such as the one we're in right now, the philosophy of "better safe than sorry" is the way to go. Investors enjoy the certainty of knowing that no matter what happens to the price of these investments between now and the maturity date, they will mature at par.
The same can be said for the 2-year and 10-year Treasuries, but that is a longer time to wait and a lot of opportunities missed until maturity. So traders who opt for Treasuries with longer maturities have "price risk" – if they want to free that capital to invest at any point prior to maturity, they will have to take what they can get on the open market when they sell those Treasuries. Short and long term maturities offer the certainty of knowing that you can get your capital back at par, but many of the current buyers of 2-year and 10-year Treasuries will not wait until maturity to cash out. Somebody out there has been buying 2-year Treasuries, as evidenced by the chart (see figure 2).
Figure 2: 2-year U.S. Treasuries rise in price as the credit crunch intensifies. Source: Saxo Bank
This is a weekly chart of the price of 2-year U.S. Treasuries. The huge spike that appears to occur in late 2007 is a "bad tick" and should be ignored. A rising price indicates that investors are buying, and as the price rises, the yield is falling. Notice how the price begins to climb in the summer of 2007 - right around the time when the word "subprime" entered our vocabulary. Prices fell (and yields rose) in early 2008, as markets calmed down a bit, and then prices began to rise again (driving yields lower) this summer as the crisis became full-blown with the collapse of Lehman Brothers.
Regarding the TED Spread, which is explained in this previous article, it is a terrific way to gauge market fear, much like the VIX (volatility index). Both have come off of extreme highs, showing a possible light at the end of the tunnel for equity markets (see figure 3).
Figure 3: TED Spread drops suddenly, indicating greater confidence in bank lending. Source: Saxo Bank
It appears that banks are now more willing to lend money than they were last week, when the TED Spread hit its recent peak. Still, the level of fear is much higher than normal. Prior to the collapse of Lehman in September, the TED spread was about 1%. If it falls back into that 1% range, it will indicate that confidence has returned, and that the worst of the credit crisis may have passed. That would bode well for stocks, and bond prices would likely fall as traders pull money out of Treasuries and put that capital to work in the equity markets.
Have a question about Forex trading? Send an email to info@fxeducator.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
Ed Ponsi
