Trading Interest Rates Using the Smaller “Smalls”
Trading interest rates just got a whole lot easier thanks to the introduction of the Small Treasury Yield (S10Y) by the Small Exchange.
Most market participants are well aware that Tesla (TSLA) ripped higher in 2020 and that crude oil futures briefly traded below zero in April. Many have likely traded on that information.
While that same group is also probably aware that interest rates in the United States have dropped to zero, fewer have likely traded on that information.
That may be about to change thanks to the launch of the Small Exchange and the introduction of the Small Treasury Yield (S10Y)—a product that allows traders to more easily express their market opinion on interest rates.
Given their importance in everyday life, interest rates are one of the highest volume products traded on Wall Street on any given day. However, before 2020, trading such instruments was overly complex and mostly targeted toward institutional investors.
With the introduction of the Small Treasury Yield (S10Y), more market participants can access rates exposure to express a market opinion or for hedging purposes. Either way, the futures-based S10Y opens the portfolio up for additional diversification.
In terms of broader market context, interest rates historically possess a strong positive correlation with the global economy. When economic contractions occur, interest rates typically move lower, and vice versa.
This occurs because during periods of economic contraction global central banks usually lower interest rates to stimulate more borrowing. In this environment, consumers and businesses are theoretically more incentivized to borrow and invest—activities that can help grow a stagnant economy.
Central banks, therefore, use interest rates to manage the economy—lowering rates when the economy needs assistance and raising rates when the economy is overheating.
The year 2020 provides ample evidence of this relationship. The onset of the coronavirus pandemic catalyzed a cratering in global economic activity. That development, in turn, pressured global interest rates.
In the United States, interest rates are now close to zero, thanks to the sequence of events illustrated below.
Investors and traders can use knowledge like this to express an opinion on interest rate direction or protect their portfolios.
The Small Treasury Yield (S10Y) is directly tied to the percentage yield of the U.S. 10-year Treasury bond, one of the most widely accepted benchmarks for global rates. Yield is another way of expressing the concept of an interest rate, although it refers to the return side of a debt investment.
For example, a person taking on debt thinks about their obligation in terms of the associated interest rate, but the person or entity buying that debt and receiving the interest payments usually thinks about that income in terms of yield (i.e. return on investment).
The prevailing interest rate environment, therefore, has a huge influence on newly issued debt and associated yields.
Case in point, the yield on the U.S. 10-year Treasury bond declined to a record low in March 2020 in tandem with plummeting interest rates (illustrated through prevailing mortgage interest rates), as shown below.
Based on the above, that means an investor or trader expecting interest rates to rise (reflected in rising Treasury yields) might consider purchasing the S10Y. Conversely, a trader expecting interest rates to decline might sell the S10Y.
It should be noted, however, that while interest rates and yields are highly correlated, they are not 100% correlated.
For example, the Federal Reserve has stated that benchmark interest rates (i.e. the federal funds rate) should remain near-zero for some time. But, that doesn’t mean the 10-year Treasury yield won’t move in the interim.
These days, perceptions over the strength of the U.S. economy can move yields, even without corresponding moves in short-term benchmark rates.
For example, if a second stimulus package is eventually passed by Congress, yields on government bonds (like the 10-year) could move higher on confidence that the economic recovery might be stronger than expected in 2021.
On the other hand, if another economic shock were to develop, one could easily see Treasury yields moving lower, despite the fact that interest rates are already close to zero.
Ultimately, yields move based on the direction of U.S. Treasury bonds. When pessimism overtakes the market, many market participants flock to U.S. Treasuries due to the perceived safety in such instruments, given they are backed by the “full faith and credit” of the U.S. government.
Bond prices and yields share a strong inverse correlation, meaning that as demand drives bond prices higher (during a “flight to safety,” for example), yields typically move lower. The opposite is true when Treasury bonds are being sold, when yields rise. That’s why the 10-year Treasury yield was driven down to its lowest-ever level during the panic this past March, touching 0.318%.
Today, the 10-year yield is trading about 0.92%, which is still significantly lower than pre-pandemic levels.
By tracking the health of the economy, interest rates and government bond prices, market participants will gain a better understanding of why treasury yields are moving, and in the process potentially unlock new trading opportunities.
As always, it can be prudent to “mock trade” (i.e. paper trade) a new product before deploying a “live” position, just to better understand associated risk dynamics.
To learn more about trading interest rates using the Small Treasury Yield, readers are encouraged to review the following programming on the tastytrade financial network:
- Small Stakes: Introducing the Small Treasury Yield (S10Y)
- Small Stakes: How to Trade Interest Rate Futures
- Small Stakes: Managing Stock Risk with Bonds
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Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.
