24 June 2007 Note: Always use Eurodollar contracts which are 6-12 months to expiration (preferably close to 9 months).

(June 9) The Yield Curve has broken out above the polytrendline as the realization of rising rates finally hits the bond market. Conservative investors can take advantage of the trend to higher rates via the RisingRates.com funds as we have talked about in the past.

The trend in the Eurodollar remains down, but the oversold condition argues that a bounce is due. Eurodollars have been going down in price (higher in yield), but the downward momentum is higher in bonds than in Eurodollars, making the spread gain value. As you can see from the long bond futures chart above (here, we are showing the expiring June contract due to the fact that the current front month September does not have enough price history to show that current prices are close to last year's lows), there could very well be an oversold bounce in bonds soon. This rally is going to be due to a very fundamental factor: the housing sector, which had been trying to recover, is going to be (is being) slammed by higher mortgage rates. There may be a reversal in the psychology of the bond pits in that the Fed will be seen as becoming more prone to cut short term rates than tighten them. Once that shift occurs, Eurodollars could rally sharply. But, technically, there's no sign of that yet.

The spread between Eurodollars and bonds (five contracts long the Eurodollar interest rate contract -- not Euro Currency! -- and one contract short the Treasury Bond contract in the futures) is showing a contracting triangle. This tells us that there is one more plunge in bonds, probably to test last year's lows, directly ahead. Once bonds find a temporary bottom (and, make no mistake about it, the longer term trend in long term interest rates is higher, lower in price), that spread will lose value. So, if you're looking to trade the spread, be very aware of this reversal possibility in the near term. The coming correction of the recent runup should give more conservative traders a much better entry point than right now.

Intraday Spread Trading

Another way to handle the spread is to drop the losing leg on a reversal. This converts the spread into an outright position which can be maintained, with proper stops, of course, until the move reverses again. In this way, the spread can be maintained, but short term exposure to an outright position can enhance returns. This is obviously a strategy suited for those who have the luxury of monitoring and adjusting the position intraday.

Longer Term Spread Investing

Otherwise, for those who are not in a position to monitor the market intraday, the spread is an ideal way to take a position on the longer term trend, which we believe is for lower short term rates and higher long term rates. We noted Friday that Bill Gross of PIMCO is looking for similar moves over the next 3-5 years. In other words, he is looking for the housing sector to slow the economy enough to force the Fed to lower short term rates while the long end of the bond market continues to price in inflation. The spreads we are talking about here seek to profit from that long term trend.

We are also showing a companion spread between Eurodollars and the 10-Year Treasury Note contract. This one has a different ratio, 5:2, of contracts between sides: 5 for the Eurodollar on the long side, which is the same as the other spread, but 2 for the 10-year note on the short side. The margin requirement is only slightly higher at about $811 per position. This spread has gained more recently due to the plunge in the price of 10-year notes and the fact that it doubles the number of contracts on the short side.

If you're not a current subscriber and want up-to-date information about these kind of trades, be sure to sign up for a free trial today!