SR3: Trading Opportunities in a Disrupted Treasury Market
CBOT: Three-MO SOFR Futures ( 
SR31!)
Breaking News: The US Treasury bonds are risk-free No Longer!
Last Friday, top credit ratings agency Moody's lowered its credit outlook on the U.S. to "negative" from "stable", citing large fiscal deficits and a decline in debt affordability. It has so far maintained the AAA credit rating for U.S. sovereign bonds.
This move follows a rating downgrade by Fitch, another major ratings agency. On August 1st this year, Fitch cut U.S. credit rating from AAA to AA+, a decision made following months of political brinkmanship around the U.S. debt ceiling.
Going back, the S&P was the first credit agency to give Uncle Sam a bad grade. It cut the U.S. credit rating from AAA to AA+ in August 2011 and has maintained it ever since.
U.S. credit rating is now lower than that of Australia, Canada, Denmark, Germany, Luxemburg, Netherlands, Norway, Singapore, Sweden, Switzerland, and the European Union. These countries all enjoy AAA ratings from the top-3 major ratings agencies.
The risk-free assumption on US Treasury bonds has long been the foundation of the global credit market. It typically measures the riskiness of a debt issue by adding risk premium(s) on top of a risk-free interest rate, which by default is the Fed Funds rate.
If the U.S. bonds are no longer deemed risk-free, should we change “the mother of all reference rates” with a new risk-free rate? It would be like cracking the foundation of the Empire State Building and will bring chaos to the $133-trillion global bond market.
In my opinion, this Doomsday scenario is very unlikely to occur. ‘A revisit of the following high-profile credit market events helps us understand why.
August 2011: the S&P downgraded U.S. credit rating
On August 5, 2011, the S&P announced its decision to give its first-ever downgrade to U.S. sovereign debt, lowering the rating by one notch to "AA+", with a negative outlook. S&P was direct in its criticism of the governance and policy-making process, which took the U.S. to the brink of default as part of the 2011 U.S. debt-ceiling crisis.
This unprecedented downgrade drew sharp criticism from the Obama administration and the U.S. Congress, but the S&P refused to budge. What did the investors think?
• The 10-Year Note with a par value of 100 traded at around 130 before the downgrade. A month later, its price hardly moved. By year end 2011, the 10Y note rose to 132.
• The 30-Year Bond was quoted at 136. It reached 145 by year end, up 6.6%.
• Following the downgrade, the S&P 500 lost 7.6% in August. But it quickly rebounded. The S&P ended the year at 1,258, up 3.3% from before the downgrade.
I rephrase a famous quote to explain what happened: “When the U.S. sneezes, the World catches a cold.” The U.S. downgrade created a bigger chao in global markets. Investors pulled money out of emerging markets, which were considered even riskier. They put money back in the U.S. stocks and bonds, which, ironically, are deemed safer.
There has not been any long-term impact from the S&P downgrade, or from its decision to keep U.S. rating at the less-than-perfect rating:
• The S&P settled at 4,415 last Friday, up 260% since the downgrade in 2011;
• US GDP has grown from $15.6 trillion in 2011 to $25.5 trillion in 2022, up 63%;
• In 2011, US national debt totaled $14.8 trillion, a level the S&P considered as “unsustainable”. It has now mushroomed to $33.7 trillion, up 128%. The U.S. government has not defaulted on any debt or missed any interest payment.
August 2023: Fitch downgraded U.S. credit rating
In a surprise move on August 1st, Fitch downgraded U.S. Treasuries to AA+ from AAA.
The U.S. markets were already in decline following the July 25th Fed decision to raise interest rates by 25 bps to 5.25-5.50%. Markets were clearly driven by the Fed, and the Fitch downgrade was merely a footnote.
• The 10-Year Note traded at around 112 at the time of the downgrade. It fell as much as 6% to 105. The 10Y note has recovered somewhat to 107 by Monday.
• The 30-Year Bond was quoted at 136. It dipped to 108 (-20%) by October, and it’s now quoted at 113, a rebound of nearly 5%.
• Following the July rate hike, the S&P 500 has dropped from 4,588 to 4,117, a sharp 10% drawdown. However, it has since staged ten winning streaks, pushing the index back to 4,415, an impressive 300-point rebound (+7.2%).
November 2023: Moody’s lowered U.S. credit outlook
Last Friday November 10th, Moody's kept U.S. credit rating at AAA, but lowered its outlook to "negative" from "stable", citing large fiscal deficits and a decline in debt affordability.
• The 10-Year Note ended the day at 4.646%, a modest gain of 0.016%.
• The 30-Year Bond was settled 4.756%, down 0.011%.
• The S&P 500 closed at 4,415, up 68 points or +1.6%.
The U.S. hardly moved on Monday, as investors waited for the new inflation data. Today, the BLS reports that October CPI was unchanged from previous month, with the annual headline CPI dropping to 3.0%, below market expectations. The S&P pushed up 2% to reach 4,500 in morning trading. There you see how little the impact from a downgrade.
Trading with CBOT SOFR Futures
In “SOFR: Farewell to LIBOR”, published on July 3rd, I explained that the Securitized Overnight Funding Rate (SOFR) has already replaced the London Interbank Offering Rate (LIBOR) as the leading global credit market benchmark.
If you are curious about what this means to you, check out your credit card agreement. You would find that the bank interest rate calculation usually consists of a “prime rate” and a markup, where the prime rate is defined as the sum of SOFR and a fixed rate.
CBOT 3-Month SOFR Futures (
SR3) lists 40 quarterly contracts. It shows what the SOFR would be, quarter by quarter, ten years down to road. Based on Friday settlement prices and volume, here is the market consensus on SOFR through the end of 2024:
• Current Fed Funds rate: 5.25-5.50%
• December 2023 SOFR: 5.415%, volume: 265,153
• March 2024 SOFR: 5.350%, volume: 283,053
• June 2024 SOFR: 5.140%, volume: 324,902
• September 2024 SOFR: 4.880%, volume: 469,238
• December 2024: SOFR: 4.605%, volume: 402,005
SOFR futures are the most liquid futures contracts in the world. On Friday, 2,787,432 lots changed hands. Open interest was 10,655,832 contracts. The contracts showed here each traded over a quarter million lots in a single day. We could assume that market prices reflect best investor consensus on interest rate level at any given time in the future.
Here are my observations:
• The lead December contract is quoted at 5.415%, in line with the current Fed Funds range of 5.25-5.50%. It dropped to 5.3675% Tuesday after the CPI data.
• The September 2024 quote of 4.635% on Tuesday, is 62-87 bps below range, indicating 2-3 rate cuts of 25 bps within the next ten months.
• The December 2024 quote of 4.330% is 92-107 bps below range, indicating three to four rate cuts by the end of next year.
In my opinion, the Fed decision, the Fed Chair statement and the latest data on payrolls and inflation, sent conflicting signals to the market, creating confusion among investors. Market prices are temporarily dislocated, which may present trading opportunities.
The September 2024 quote indicates two or three rate cuts. I think that this assumption is too aggressive. The Fed, in both its statements and the Fed Chair public comments, repeatedly stressed that it never raised the issue of if or when to cut rates.
If a trader holds the view that the September SOFR rate shall rise, he could express it with a short position in SOFR futures. The quoting convention of SOFR future is 100-R, where R is the effective interest rate. If the rate goes up, futures price will go down.
SOFR contracts have a notional value of $2,500 x contract-grade IMM Index. Each 1 basis-point move would result in a gain or loss of $25 per contract. The minimum margins are $850 for the September contract.
Hypothetically, if the trader is correct and the rates turn out to be 25 bps high, he would have a theoretical return of $625 per contract (= 25 X 25).
The trader would lose money if the Fed cut rates faster than anticipated.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
SR31!)Breaking News: The US Treasury bonds are risk-free No Longer!
Last Friday, top credit ratings agency Moody's lowered its credit outlook on the U.S. to "negative" from "stable", citing large fiscal deficits and a decline in debt affordability. It has so far maintained the AAA credit rating for U.S. sovereign bonds.
This move follows a rating downgrade by Fitch, another major ratings agency. On August 1st this year, Fitch cut U.S. credit rating from AAA to AA+, a decision made following months of political brinkmanship around the U.S. debt ceiling.
Going back, the S&P was the first credit agency to give Uncle Sam a bad grade. It cut the U.S. credit rating from AAA to AA+ in August 2011 and has maintained it ever since.
U.S. credit rating is now lower than that of Australia, Canada, Denmark, Germany, Luxemburg, Netherlands, Norway, Singapore, Sweden, Switzerland, and the European Union. These countries all enjoy AAA ratings from the top-3 major ratings agencies.
The risk-free assumption on US Treasury bonds has long been the foundation of the global credit market. It typically measures the riskiness of a debt issue by adding risk premium(s) on top of a risk-free interest rate, which by default is the Fed Funds rate.
If the U.S. bonds are no longer deemed risk-free, should we change “the mother of all reference rates” with a new risk-free rate? It would be like cracking the foundation of the Empire State Building and will bring chaos to the $133-trillion global bond market.
In my opinion, this Doomsday scenario is very unlikely to occur. ‘A revisit of the following high-profile credit market events helps us understand why.
August 2011: the S&P downgraded U.S. credit rating
On August 5, 2011, the S&P announced its decision to give its first-ever downgrade to U.S. sovereign debt, lowering the rating by one notch to "AA+", with a negative outlook. S&P was direct in its criticism of the governance and policy-making process, which took the U.S. to the brink of default as part of the 2011 U.S. debt-ceiling crisis.
This unprecedented downgrade drew sharp criticism from the Obama administration and the U.S. Congress, but the S&P refused to budge. What did the investors think?
• The 10-Year Note with a par value of 100 traded at around 130 before the downgrade. A month later, its price hardly moved. By year end 2011, the 10Y note rose to 132.
• The 30-Year Bond was quoted at 136. It reached 145 by year end, up 6.6%.
• Following the downgrade, the S&P 500 lost 7.6% in August. But it quickly rebounded. The S&P ended the year at 1,258, up 3.3% from before the downgrade.
I rephrase a famous quote to explain what happened: “When the U.S. sneezes, the World catches a cold.” The U.S. downgrade created a bigger chao in global markets. Investors pulled money out of emerging markets, which were considered even riskier. They put money back in the U.S. stocks and bonds, which, ironically, are deemed safer.
There has not been any long-term impact from the S&P downgrade, or from its decision to keep U.S. rating at the less-than-perfect rating:
• The S&P settled at 4,415 last Friday, up 260% since the downgrade in 2011;
• US GDP has grown from $15.6 trillion in 2011 to $25.5 trillion in 2022, up 63%;
• In 2011, US national debt totaled $14.8 trillion, a level the S&P considered as “unsustainable”. It has now mushroomed to $33.7 trillion, up 128%. The U.S. government has not defaulted on any debt or missed any interest payment.
August 2023: Fitch downgraded U.S. credit rating
In a surprise move on August 1st, Fitch downgraded U.S. Treasuries to AA+ from AAA.
The U.S. markets were already in decline following the July 25th Fed decision to raise interest rates by 25 bps to 5.25-5.50%. Markets were clearly driven by the Fed, and the Fitch downgrade was merely a footnote.
• The 10-Year Note traded at around 112 at the time of the downgrade. It fell as much as 6% to 105. The 10Y note has recovered somewhat to 107 by Monday.
• The 30-Year Bond was quoted at 136. It dipped to 108 (-20%) by October, and it’s now quoted at 113, a rebound of nearly 5%.
• Following the July rate hike, the S&P 500 has dropped from 4,588 to 4,117, a sharp 10% drawdown. However, it has since staged ten winning streaks, pushing the index back to 4,415, an impressive 300-point rebound (+7.2%).
November 2023: Moody’s lowered U.S. credit outlook
Last Friday November 10th, Moody's kept U.S. credit rating at AAA, but lowered its outlook to "negative" from "stable", citing large fiscal deficits and a decline in debt affordability.
• The 10-Year Note ended the day at 4.646%, a modest gain of 0.016%.
• The 30-Year Bond was settled 4.756%, down 0.011%.
• The S&P 500 closed at 4,415, up 68 points or +1.6%.
The U.S. hardly moved on Monday, as investors waited for the new inflation data. Today, the BLS reports that October CPI was unchanged from previous month, with the annual headline CPI dropping to 3.0%, below market expectations. The S&P pushed up 2% to reach 4,500 in morning trading. There you see how little the impact from a downgrade.
Trading with CBOT SOFR Futures
In “SOFR: Farewell to LIBOR”, published on July 3rd, I explained that the Securitized Overnight Funding Rate (SOFR) has already replaced the London Interbank Offering Rate (LIBOR) as the leading global credit market benchmark.
If you are curious about what this means to you, check out your credit card agreement. You would find that the bank interest rate calculation usually consists of a “prime rate” and a markup, where the prime rate is defined as the sum of SOFR and a fixed rate.
CBOT 3-Month SOFR Futures (
SR3) lists 40 quarterly contracts. It shows what the SOFR would be, quarter by quarter, ten years down to road. Based on Friday settlement prices and volume, here is the market consensus on SOFR through the end of 2024:• Current Fed Funds rate: 5.25-5.50%
• December 2023 SOFR: 5.415%, volume: 265,153
• March 2024 SOFR: 5.350%, volume: 283,053
• June 2024 SOFR: 5.140%, volume: 324,902
• September 2024 SOFR: 4.880%, volume: 469,238
• December 2024: SOFR: 4.605%, volume: 402,005
SOFR futures are the most liquid futures contracts in the world. On Friday, 2,787,432 lots changed hands. Open interest was 10,655,832 contracts. The contracts showed here each traded over a quarter million lots in a single day. We could assume that market prices reflect best investor consensus on interest rate level at any given time in the future.
Here are my observations:
• The lead December contract is quoted at 5.415%, in line with the current Fed Funds range of 5.25-5.50%. It dropped to 5.3675% Tuesday after the CPI data.
• The September 2024 quote of 4.635% on Tuesday, is 62-87 bps below range, indicating 2-3 rate cuts of 25 bps within the next ten months.
• The December 2024 quote of 4.330% is 92-107 bps below range, indicating three to four rate cuts by the end of next year.
In my opinion, the Fed decision, the Fed Chair statement and the latest data on payrolls and inflation, sent conflicting signals to the market, creating confusion among investors. Market prices are temporarily dislocated, which may present trading opportunities.
The September 2024 quote indicates two or three rate cuts. I think that this assumption is too aggressive. The Fed, in both its statements and the Fed Chair public comments, repeatedly stressed that it never raised the issue of if or when to cut rates.
If a trader holds the view that the September SOFR rate shall rise, he could express it with a short position in SOFR futures. The quoting convention of SOFR future is 100-R, where R is the effective interest rate. If the rate goes up, futures price will go down.
SOFR contracts have a notional value of $2,500 x contract-grade IMM Index. Each 1 basis-point move would result in a gain or loss of $25 per contract. The minimum margins are $850 for the September contract.
Hypothetically, if the trader is correct and the rates turn out to be 25 bps high, he would have a theoretical return of $625 per contract (= 25 X 25).
The trader would lose money if the Fed cut rates faster than anticipated.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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