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If Only We Could Be Alerted When Rates Begin to Rise …

By: Robert Worrell

Imagine how differently you would manage your bank and how much more profitable it could be if you were alerted before interest rates began to rise. You could maximize your income while minimizing your interest rate risk. What more could you want? Among the many indicators we at Country Club Bank monitor, there are two that we track closely and use as tools to aid in managing our interest rate risk. Knowing that we can manage our interest rate risk provides us the opportunity to be more comfortable investing further out on the curve than we would otherwise in these days of high uncertainty. The two indicators that currently have our attention in particular are the monthly non-farm payrolls announcement and the deferred eurodollar futures contract market.

Non-farm payrolls tracks the employment picture and speaks volumes about our economy. Even though it reports employment gains and losses for previous months, in my opinion, it is as much a leading indicator as it is a lagging one.

Others agree. A Bloomberg News survey from December 2009 ranked employment levels and job formation as the most accurate forecaster of gross domestic product. Without a healthy employment picture, one cannot expect an improvement in the economy. At the time of this writing, non-farm payrolls report a grim employment picture.

The yield of the two-year Treasury reflects the employment picture. Currently, the two-year Treasury yields 53 basis points, which is near the lowest on record. To put that into perspective, a 53-basis-point yield translates to a $5.30 interest payment per year on a $1,000 investment. How can a banker make any money in an environment with weak loan demand and bond yields where they are? Can you afford to lengthen the duration of your investment portfolio to improve your earnings? After all, the yield curve is extremely steep. Currently, the spread between the two-year Treasury and the 10-year Treasury is 229 basis points. That is an additional $22.90 per $1,000 dollar investment for buying the 10-year Treasury as opposed to the two-year. That is greater than four times the earnings potential.

Of course, the deterrent to lengthening your duration and taking advantage of the steep yield curve is the additional interest rate risk incurred. This is where we turn to a second barometer, the deferred eurodollar futures contract market as our leading timing indicator.

At Country Club Bank, we follow the deferred eurodollar futures contract market for guidance as to when rates will rise. While no indicator is fool proof, this market is considered a valuable tool capable of indicating when rates will rise. Eurodollar futures contracts represent the market’s expectation of the three-month LIBOR rate. This matters because most rates, even deposit rates, are in some way, shape or form related to three-month LIBOR.

It is important to note that it is a timing indicator, not a forecasting indicator. We know better than to attempt to forecast levels. We do not know when rates will rise, but when they do, the eurodollar futures contract will alert us, so we can be ready.

Only the largest institutional players use the deferred eurodollar futures contracts in significant size to hedge their positions. Because this is an instrument widely used by those who are often central to the fate of interest rates, it can be used as a timing indicator as to when rates will begin to rise. The chart graphs the eurodollar futures contract for December 2011. At the time of this writing, the contract price was 99.06, which represented a market forecast of 0.94 (100 minus 99.06) for three-month LIBOR in mid-December 2011. If the price of the eurodollar futures contract trends upward, as has been the case, then the market is realizing that its forecast (0.94 in our example) is too high. Thus, the market rallies. However, once the eurodollar futures contract price trend changes from upward to downward, you have an indication of a likely rise in rates to come. Importantly, this provides a signal to sell longer maturity bonds and shorten your duration. Until the indicator changes, focus on prudently maximizing earnings from your investment portfolio. It will serve your bank well.

Robert Worrell is vice president, Capital Markets Group, at Country Club Bank, Kansas City. Contact him at rworrell(at)countryclubbank.com.

Copyright © September 2010 BankNews Media


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