Interest rates are the most important financial measure for the global financial system. All financial markets and businesses are dependent on interest rates. High interest rates increase the cost of doing business and force many businesses that are highly leveraged into bankruptcy. Low interest rates help the economy as well as the business grow. Now, one of the ways to profit from the increase or decrease in interest rates is by trading interest rate futures. Most popular are the Eurodollars and and the Treasury Bills, Notes and Bonds.
As a futures trader, US Treasury Bonds Futures should be very important for you. However, in this decade the European Bond Market and the bond markets in China and Dubai are going to play increasingly significant roles. So the bond market is at the center of the financial world. At the center of the bond market is the US Federal Reserve (FED) and the way it raises and lowers the interest rates.
The connection between the bond market, the FED and the rest of the financial markets is fundamental to understanding how to trade interest rate futures and how to invest in general. FED does not control the long term interest rates in the markets. So how does FED influence the interest rate in the economy?
FED has got two policy instruments at its disposal. The first policy instrument at its disposal is the FED Fund Rate. This is the overnight lending rate that the banks charge one another for meeting their stipulated reserve requirements. FED sets the Fund Rate. The other policy instrument is the Discount Rate at which FED lends money to insolvent banks.
Now how does the FED FUND RATE trickles down through the rest of the economy. Let's see how it works. Suppose, FED is worried about the overheating of the economy and the rise in inflation. One of the primary jobs of the FED is to control inflation in the economy. So, the FOMC decides to increase the FED FUND RATE. This increase forces the banks and the credit card companies to increase their prime rates that they charge their best customers. Now, when bond traders sense an increase in the interest rates, they start selling their bonds in the market. This increases the market interest rates further. Auto loans and the home equity plus mortgage loans are tied with these bond benchmark rates, so they increase as well. So, you can see, how a chain reaction develops in the economy. This increase trickles down through the economy with a time lag that might be as long as from six months to more than one year.
So, if you want to profit from the changes in the interest rates, you can trade FED Fund Rate Futures that get traded on CME (Chicago Mercantile Exchange). These futures contracts are a pure bet on the FED decision making at FOMC. You can also trade LIBOR Futures. LIBOR means that London Interbank Offer Rate. This is the rate that commercial banks charge each other and is widely used all over the world as a benchmark. Another popular contract is the Eurodollars and the EURYEN deposits.
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