Interest Rates - A Ticking Time Bomb

by: Matthew Bradbard

What if I told you I can personally guarantee interest rates will never go below zero (0%)? [I cannot say this, and will never say this, of course.]

And what if I told you it's possible interest rates could go as high as 4%... or 8%... even 19% over the next several years? [I CAN say this. Not only is it possible, it's happened before]. Of course, past performance is not indicative of future results.

And what if I told you there's a way to profit from the seemingly inevitable rise in interest rates… by trading one of the most liquid futures markets… with a well-defined level of risk?

Would you be interested?

I'll tell you up front: this could be the mother of all trades! Okay, okay… Before we get ahead of ourselves, let's take a quick review of interest rates -- past, present and future. Then, I'll let you decide for yourself if this trade is more of a rainmaker or a widow-maker.

Interest Rates Pinned to the Floor

Today, the effective Fed Funds Rate is 0.15%. You could say rates have been "pinned to the floor" since the Fed set a target of 0-0.25% in January 2009.

Not only has the Fed held rates at this level for 39 consecutive months, these are some of the lowest Fed Funds Rates in history. Second place goes to May 1958, when the rate was 0.63%. Rounding out this brief history lesson, we've seen interest rates as high as 19.1% (June 1981). Basically, we experienced over two decades of rising interest rates heading into 1981. And then more than three decades of falling interest rates from 1981 onward. You'll see the long-term perspective in the chart below. (Can you see now why targeting the next decade-long interest rate trend has the potential to be a once-in-a-generation trade?)

Don't get it twisted… interest rates are at record low levels for one simple reason: the Fed. This is not a free market rate. This is an artificial, Fed-rigged rate… proving that, for the moment, Adam Smith's invisible hand is being overpowered by Ben Bernanke's fat finger.

This can't go on forever. I'm a firm believer in free markets. We'll have our day soon enough, in my opinion.

With rates effectively at 0%, there is infinitely more room to the upside than the downside. Economists can debate all they want… Should we fear inflation or deflation? Is the credit crunch completely behind us? Has the real estate market bottomed, or just dead cat bounced? Will global markets catch the next eurozone crisis bug? What's the next shoe to drop? Can we justify the strength in U.S. equity markets? These debates provide plenty of fodder, but bottom line: nobody knows for sure.

What I do know is, the Federal Reserve can't keep rates pinned to 0% forever. Eventually, either the economy will improve, or reckless monetary stimulus will fuel inflation, and the Fed will have to back down. Even more, they'll have to reverse course and raise rates at some point.

So enough about rates… let's get to the trade!

Eurodollars: A One-Way Trade?

Despite a misleading name, there is nothing "European" about Eurodollars. And they have nothing to do with the euro currency.

Eurodollars are simply bank deposits, denominated in U.S. dollars, held in foreign banks. As these are outside the U.S. banking system, they're also outside the jurisdiction of the Federal Reserve. Consequently, the deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins.

Like most financial markets, Eurodollars can be traded via futures contracts offered by the Chicago Mercantile Exchange (CME). Basically, Eurodollars track the 3-month USD LIBOR rate. Specifically, Eurodollar futures prices are determined by the market's collective forecast of what the LIBOR rate will be on the delivery/expiration date of the futures contract.

So here's how the futures pricing works… A futures contract price of 100.0000 implies an expected LIBOR rate of 0%. The anticipated annualized LIBOR rate is subtracted from 100 to arrive at the futures contract price. For instance, if futures traders anticipate a LIBOR of 3.0%, futures contracts should be priced at 97.0000. On each future contract's expiry date, settlement is based on the current 3-month LIBOR rate.

As with other fixed rate instruments, futures prices fall as yield rises (and vice versa). Therefore, traders buy CME Eurodollar futures if they anticipate falling interest rates. Likewise, we sell CME Eurodollars on expectations of rising rates.

To illustrate my point, here's a chart of 3-month LIBOR rates. You'll see an upturn in rates between 2003 and 2007, when LIBOR went from 1.1% to 5.5%.

As LIBOR climbed 4.4% in four years, Eurodollar futures declined 4.5 points, from 99.0000 to 94.5000. See here…

Now, some specifics on this contract's specifications… Each CME Eurodollar futures contract has a notional value, or "face value," of $1,000,000. Of course, it won't cost you that to trade; you'll need just under $1,000 in margin to buy/sell one contract. Each tick equates to a $25 move in your P/L and every full point (i.e., a move from 99.00 to 98.00) equates to $2,500 gained/lost.

Now consider the potential risk in a short futures position. Let's assume you get short futures at 99 even. If rates go to zero, and you hold until expiration, you stand to lose $2,500 per contract, not including fees/commissions. Of course, this assumes that if LIBOR goes to 0%, futures will be locked in at 100. While a negative LIBOR rate and a Eurodollar futures contract over 100 is theoretically possible… I'm not aware of this ever happening.

Here's one last chart, showing the December 2015 Eurodollar contract with prices currently at 99.0500. Again, the dollar risk of a move to par (100) from current levels is just $2,375 per contract (100.00 - 99.05 = 95 ticks, at $25/tick… risk = $2,375).

The potential profit I see is much greater than the risk. Even a moderate move to 3% LIBOR should put the Eurodollar at 97.00. This move would earn a short seller just over two points, or roughly $5,000 per contract in profits. And in my opinion, a hike to 3% could only be the beginning…

Perfect Vehicle, Perfect Trade?

Trading in Eurodollar futures is extensive, offering uniquely deep liquidity. It is also a very deep options market, giving us the opportunity to buy long-dated (2015 and 2016) puts without getting killed on the notoriously wide spreads of illiquid markets. Right now, we're able to buy at-the-money puts with more than two years of time to expiration for under $800! That's a no-brainer, in my opinion. Plus, investors should appreciate the limited, defined risk of long options -- the most you can lose is the premium you pay, plus any fees.

Like always, do your homework and make your own deductions. Where do you think interest rates are going from here? If you say "down," consider being a Eurodollar bull. If you think interest rates will be higher in two or three years, you're a Eurodollar bear.

As for myself, I'll be advising clients to be Eurodollar bears. We'll be shorting futures outright and purchasing long-dated put options. With more than sufficient liquidity, it will behoove us to scale into positions using the late 2015 and early 2016 contracts. This will give us some flexibility in managing the trade as market conditions fluctuate. The difficult part of this trade is the timing!

Drawing a comparison to the Japanese yen… everybody and their brother thought it was grossly overvalued and due for a spiraling drop by late 2010. Yet short-sellers got chopped to pieces in 2011 and most of 2012 as the yen took far longer to crack than most expected. The trade was even called the "widow-maker" for its harsh punishment of traders who "had it right" directionally, but who were also far too early.

That's why we can't simply dive in head first. We might be early. We may need to roll positions multiple times before the trade works out. Instead of going "all in" today, I'm suggesting we scale into the position over the course of the year. Think of it as our way of "dollar cost averaging" -- steadily adding to the position as short-term price moves give us favorable entry points.

Risk Disclaimer: The opinions contained herein are for general information only and not tailored to any specific investor's needs or investment goals. Any opinions expressed in this article are as of the date indicated. Trading futures, options, and Forex involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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