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Friday, October 18, 2024

The Yield Play: Long-Term Bonds Benefit as Interest Rates Dip

By Century Financial in 'Investment Insights'

The Yield Play: Long-Term Bonds Benefit as...
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U.S. Treasury Bond Ultra: Product Details

The U.S. Treasury Bond Ultra is a futures contract that tracks the price movement of the most recently issued 25-year and 30-year U.S. Treasury bonds. Investors can use it to hedge their risk against rising interest rates or to speculate on the direction of bond prices. Futures contracts for the U.S. Treasury Bond Ultra are available on both the Century Trade and TradeUltra platforms.

 
Contract Specification
Underlying U.S. 30-Year 6% Bond
Contract Size $100,000

Source: Bloomberg
Date: 16th October 2024

 

Fed: The Path Ahead

The U.S. economy has held up remarkably well despite a challenging macroeconomic backdrop marred with geopolitical tensions in the Mideast, sluggishness in the U.S. housing and manufacturing sectors, and uncertainty pertaining to the upcoming U.S. presidential elections.

The Federal Reserve kickstarted its monetary easing cycle on a strong footing – initiating a 50-bps rate cut in September and lowering the fed funds target rate to a range between 4.75% to 5.00%.

Economic reports in the aftermath of the September FOMC have painted a mixed picture about the health of the U.S. economy, particularly the labor market. For starters, the unemployment rate ticked slightly lower to 4.1% while non-farm payrolls blew past expectations with a total of 254,000 in September. This alleviated concerns about a teetering labor market and reinforced the Fed’s soft-landing narrative. Meanwhile, headline inflation in the U.S. accelerated at a slightly higher-than-expected rate of 2.4% in September. By virtue of these strong economic reports, markets had to considerably lower expectations of a 50-bps rate cut in November. Nevertheless, with two FOMC meetings remaining this year and about 45-50 bps rate cuts priced in for the remainder of 2024, there is a chance of seeing a quarter point reduction at each rate-setting meeting, supporting the outlook for U.S. Treasury Bond Ultra.

 

Euro Buxl: Product Details

The Euro Buxl futures are a natural complement to the EU bonds market , offering traders and investors a direct means to manage their long-term interest rate risk and portfolio duration. Euro Buxl futures ("Buxl”) consist of cash Euro bonds with at least 24 to 35 years of remaining term to maturity. This product is available on the Century Trader platform under the description “Euro Buxl - Cash” and the Ticker “EUROBUXL.”

 
Contract Specification
Underlying German 30-Year 4% Bond
Contract Size EUR 100,000

Source: Bloomberg
Date: 16th October 2024

 

ECB: The Path Ahead

The European Central Bank is set to implement its third interest rate cut for the year at its upcoming meeting, as officials note that inflation risks are diminishing more rapidly than previously anticipated. In September, headline inflation in the euro area eased to 1.8%, falling below the central bank's 2% objective. Core inflation, which excludes the more volatile elements like energy, food, alcohol, and tobacco, reached a 2.7% from a previous 2.8%.

Anticipation for a swifter monetary easing process has increased since the ECB meeting on September 12, following a string of dovish remarks from officials and lower-than-expected inflation reports from eurozone countries, including Germany. The expectation of consecutive rate cuts has also been heightened by the ongoing sluggishness in economic activity across the eurozone.

The composite purchasing managers' index data, assessing services and manufacturing activity, indicates stagnation in the third quarter following modest 0.3% growth in the second quarter. This projection is influenced by a cooling labor market and slower wage growth, which are anticipated to push down services inflation in the upcoming months. Analysts foresee this as the beginning of an accelerated path towards 2% rates by June 2025 and further down to 1.5% by the end of 2025. This outlook supports a positive sentiment for Buxl prices.

 

U.S. Treasury Bond Ultra

Regression Analysis

Regression analysis is a useful tool for assessing the strength of relationships between different variables and modelling how these relationships will evolve in the future. The model below forecasts the movement in the T-Bond Ultra’s price when the 30-year U.S. government yield changes.

As of 16th October 2024, the regression equation over two years is as follows:

Y = -20.067 X + 214.017

The standard deviation of error is 1.326, and the study assumes a 90% confidence interval.

 
Scenario Analysis
Change in Yield Estimated U.S. 30-Year Government Bond Yield Estimated T-Bond Ultra Price Estimated % Change in T-Bond Ultra
Current Levels 4.28% $129.66 Base Case
Yield Decreases by 75 bps 3.53% $146.40 12.91%
Yield Decreases by 150 bps 2.78% $161.45 24.52%
Yield Increases by 75 bps 5.03% $116.30 -10.30%
Yield Increases by 150 bps 5.78% $101.25 -21.91%

Source: Bloomberg
Date: 16th October 2024

 

The table above demonstrates the inverse relationship between the T-Bond Ultra’s price and the 30-year US government bond yield. If the yield declines by 75 bps to 3.53%, the bond price is projected to rise to $146.40 Conversely, if the yield increases by 75 bps to 5.03%, the bond price is expected to fall to $116.30.

 

Euro-Buxl

Regression Analysis

The model below forecasts the Euro Buxl’s price movement when the 30-year German government yield changes.

As of 16th October 2024, the regression equation over two years is as follows:

Y = -29.522 X + 209.724

The standard deviation of error is 1.250, and the study assumes a 90% confidence interval.

 
Scenario Analysis
Change in Yield Estimated German 30-Year Government Bond Yield Estimated Euro-Buxl Price Estimated % Change in Euro-Buxl's Price
Current Levels 2.47% € 135.48 Base Case
Yield Decreases by 75 bps 1.72% € 161.96 19.54%
Yield Decreases by 150 bps 0.97% € 184.10 35.89%
Yield Increases by 75 bps 3.22% € 117.68 -13.14%
Yield Increases by 150 bps 3.97% € 95.54 -29.48%

Source: Bloomberg
Date: 16th October 2024

The table above demonstrates the inverse relationship between the Euro Buxl’s price and the 30-year German government bond yield. If the yield declines by 75 bps to 1.72%, the bond price is projected to rise to €161.96. Conversely, if the yield increases by 75 bps to 3.22%, the bond price is expected to fall to €117.68.

Risks and Assumptions related to Back-tested trading strategies
The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
The back-tested strategy might be at risk of data dredging, which is the behavior of testing multiple hypotheses at one time, resulting in picking the data that best supports your main hypothesis.
Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
Unforeseen events can lead to variation in performance from the tested trading strategy.
The tested result has been computed with price feeds available from Bloomberg.
The testing environment has not considered transaction or any other costs.
Trading indicators used for the purpose of testing has been provided by Bloomberg.
The strategy might suffer from data mining fallacy, selection bias and backfill bias.
A trading strategy that performs well on multiple datasets from one market (e.g., forex) might not perform as well in another market (e.g., stocks).
The strategy may not depict accuracy in terms of spread changes due to the spread-widening events.

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