Saturday, July 13, 2013

Interest Rate Trading Strategies

As 2012 progressed, and especially as QE3 developed later in the year, I became convinced that a short position in Eurodollars would be lucrative (a position that gains from increasing interest rates) for a couple of reasons:

1) I think that there is too much pessimism about the unemployment rate, and that the decreasing labor force participation rate is much less cyclical than seems to be widely believed.  It is mostly a demographic and cultural shift, so that continuing falling unemployment won't need to push against a headwind of a recovering labor force participation rate.  This isn't necessarily good for our typical measures of economic output, but it would lead to interest rates increasing to more normal levels more readily.  The Fed continues to have to readjust their unemployment rate forecasts down, even as their other indicators flounder, so I believe that I have been more or less right about this.

2) I thought that QE3 would boost inflation, which it has not, at least given the fiscal context that has developed around it.  The year end fiscal deal that included tax increases and a continuation of extended unemployment benefits probably pushed against both my inflation and my unemployment forecasts.

3) These forecasted factors would help to both move the expected date of the first Fed Funds Rate increase sooner in time and increase the slope of the yield curve after that time.  In addition, I suspect that there was a kind of negative maturity premium in effect in the term structure of interest rates, due to uncertainty about the Fed's balance sheet, which was pushing rates in the 2015-2018 futures range below the pure expectations rates.

In any case, I did eventually get my sharp kick up in interest rates.  I had expected it to happen in late 2012, similar to what we saw during QE1 & QE2, but it took 9 months for it to happen, and the move probably came about without any help from current or future inflation expectations.

In addition to my forecast, I felt like I had a fairly tight window of expected losses in the Eurodollars futures market.  In September 2012, June 2017 Eurodollar contracts were priced at around 2%.  There was some danger of a Japan-type scenario that could leave short term rates at 0% indefinitely, but I felt that this risk was small.  As it happened, rates on the Eurodollar contracts fell to as low as 1.6%.  As long as there was some expectation of short term rates eventually rising, that seemed about as low as you'd need to worry about on a short contract.

So, I wanted a trading strategy that only needed to handle maybe 50 basis points of potential losses, and was poised for a quick pulse of a substantial rate increase.  Following is a chart with several trading strategies, and their performance over the past 10 months.

(Note that Eurodollars are priced at a discount from 100, so 98 is equivalent to a 2% interest rate, etc.)
The green line is a static short position.  It moves linearly with rates, and probably would have performed as well as the other strategies in this period.

The blue line is the aggressive approach.  The line shown is not a fully leveraged position, as that would have flatlined after several months of losses.  This reflects a method of reinvesting all gains back into the position aggressively, and deleveraging the position when losses are taken.  If prices don't move directionally, then this means a lot of detrimental trading - buying high and selling low.  The payout resembles being long on a series of option contracts.  It gains exponentially on sharp favorable gains, and its losses are actually more muted than in the other strategies.  But, over time, trading decay takes its toll.  On the plus side, a fully leveraged position like this that was taken with impeccable timing would see exponential gains well off the chart.  On the negative side, the chart actually shows a favorable version of this strategy, since it is based on daily closing prices.  In reality, after the first move in rates, when the contracts were in the 97.6-97.8 range, even though daily price changes don't look very volatile, intraday movements devastated more leveraged versions of this position.  But, as can be seen, even after nine months of decay, this eventually would have briefly outperformed all the other strategies, although it would require perfect timing, as the recent volatility that has come after rates peaked could have quickly removed the previous gains.

The purple line is a version of the momentum trade, but by using contracts in the 2014-2015 range, where the yield curve is convex, I had hoped that some of the trading decay of the momentum strategy would be mitigated so that the position could be held indefinitely without seeing losses from time decay.  As shown, this strategy did not work well in the current environment.  Three factors appear to be (1) the contracts in that time range are more sensitive to changes in the expected first date of short term rate increases, and most of the rate increases over this period came from a steeper yield curve after that period, (2) there is some decay in the prices of those contracts themselves that tended to dampen gains over the long term, and (3) there isn't as much volatility in those contracts.

The red line reflects a value strategy.  This is basically the opposite of the momentum strategy.  You buy low and sell high.  It is like taking a short position on a series of option contracts - large losses can be devastating, but it earns a time premium.  The parameters I used on the strategy shown here were to leverage up or down in such a way that the position would not suffer a margin call as long as the contracts were less than 98.4, so as shown here, the strategy loses power as the market price moves away from the limit price.  Further, this strategy would benefit from intraday volatility and also from pulse shocks to the contract price that commonly come from relevant market news announcements like FOMC meetings and monthly employment reports, so the performance here is probably understated.

In effect the momentum and value strategies are like a dynamic hedge, but taken for speculative purposes.  Where an option contract would have a time premium based on expected volatility, these strategies experience the time premium as it happens, based on actual volatility.

There is still uncertainty due to economic factors and Fed management, but the Eurodollar contracts do currently, in my view, reflect a reasonable expectation of forward rates given current estimates of employment growth and Fed activity.  With June 2017 Eurodollar contracts priced around 97, a two-sided value strategy might be useful in this context.  In this case, a midpoint (let's say 97) would be chosen, with a range of expected possible rates for the trading time frame.  The position would be neutral at that point, and contracts would either be sold if the price went above 97 or bought as the price went below 97.  The amount of leverage used here is important, because this position becomes increasingly compromised as interest rates move outside the range.

But, as long as one can be confident that the range is safe, you can look at this as a kind of interplay of kinetic and potential energy.  As prices move away from the midpoint target, the liquidation value of the account would decline, but the trades being made into that decline would hold a kind of kinetic energy that will be released when the price moves back to the midpoint.  At that point, the account would achieve its original value, plus a profit from the trade.  So, over time, the value of the account moves up.  This would look like the value strategy above, except with a hump in the middle and legs down on both ends, with a gradual movement upward.

At current levels of volatility, with additional frequent pulse shocks, this strategy appears to be profitable enough that if it starts with a full range of 100 basis points (96.50 to 97.50), its safe range would expand by 20 to 30 basis points a month unless the position's profits were used to increase the position size.  This would seem to allow for plenty of room to either take losses from unexpected swings in rates or from occasional repositioning of the midpoint, even while allowing the range to expand over time.

I have added the mid-point strategy to the other strategies dating from September 2012.  The position of the midpoint and the amount of leverage can be adjusted to create different payout ranges.  It looks to me like the original value strategy, which in effect used a moving mid-point and a fixed range specification, worked better when the market price was far from the target price, but that the strategy with the fixed mid-point works better as the market price matches the target.  This should be intuitively obvious, since the parameters are basically being changed here to reflect past market conditions.  The trick would be to maximize the potential leverage while avoiding catastrophic market moves.  It seems to me that it would generally be easier to have a directional position, which could always be easily changed to a midpoint strategy as the market price approached the target price.  If you are in neutral mid-point strategy, and you decide to change the mid-point in the direction of the market price, a loss would have to be incurred.  There would be a lot of psychological discipline required here, because the cost of changing the midpoint would increase as the market price deviated from the target price.  The point where changing the target would be the most expensive would be the point where the risks of not moving it would be the most dramatic.  A typical example of a seemingly standard risk/reward tradeoff that ends up being much more about emotions and confidence.


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