RATE FUTURES REPORT: Signs Of Deflation Lift Treasury Futures.

Futures are financial derivative contracts that predict the price of an underlying security at various future dates and represent today’s bets by investors of what those prices will be then. The US Treasury bonds are the most widely held and traded securities in the world and the future they predict is that of deflation. This is not surprising given the action at July 08, 2009 10-year Treasury notes auction that saw record bid to cover ratio and a sharply lower yield. And when yield curve flattens you can be that this is a good indicator of suppressed economic activity down the road.

Wall Street Journal. July 08, 2009.

RATE FUTURES REPORT: Signs Of Deflation Lift Treasury Futures.

CHICAGO (Dow Jones)–Long-end Treasury futures mounted a big rally Wednesday as falling commodity prices swept away lingering fears of inflation and fueled fresh economic concerns.

Crude oil led commodities lower as prices on the New York Mercantile Exchange slipped below $61 a barrel, a deflationary signal that helped long-end Treasury futures overcome renewed supply issues as Obama administration officials floated the idea of a second stimulus package.

There were signals too that the Federal Reserve would welcome further economic stimulus, with Chicago Fed President Charles Evans saying a second package “would be helpful.”

Treasury futures bulls were out in force ahead of Wednesday’s $19 billion 10-year note auction, and contract prices spiked past 1.5-month highs as the offering was “extremely well-bid,” according to Lou Brien, a Chicago-based market strategist with DRW Trading Group.

Anticipated yields on the 10-year Treasury note, reflected by the September-dated futures contract, had hovered around 3.5% since the beginning of the week, but plummeted as traders piled into the market.

At the close of trade Wednesday, September 10-year note futures put anticipated cash yields below 3.375%, according to Optima Investment Research.

Contracts on the 30-year bond saw bigger price gains, closing nearly two full points higher with yields seen below 4.25% at contract expiration.

The participants looked around and saw deflation everywhere,” said James Barrett, a market strategist for Lind-Waldock and a former Treasury futures trader, who cited falling prices in grains and metals alongside energy Wednesday.The value of the U.S. dollar is key to the price of long-end Treasurys, because inflation reduces fixed rates of return. If deflation is seen taking hold, investors won’t expect higher rates of return for assuming inflationary risks over a long time period.

Even though Treasury yields have fallen in recent weeks, Barrett said, the market could decide they haven’t gone down far enough as investors begin to see the economic recovery faltering.

The same issue was at play in Eurodollar futures, where contracts staged their biggest rally of the week, with the biggest price gains seen in quarterly 2010-dated contracts as market participants saw room for the Federal Reserve to continue its efforts to keep key rates low well into next year.

Eurodollar futures prices reflect market expectations for the London interbank offered rate, a global benchmark for floating-rate lending that indicates banks’ willingness to lend money.

The Libor fixed at a record low 0.525% Wednesday, a product of the Federal Reserve’s ongoing efforts to stimulate credit markets, and in light of current conditions, traders see those efforts continuing.

“The Eurodollar curve is starting to get back to the notion that the Fed is not going anywhere [with rates] for a good period of time,” said Glenn Holland, senior vice president of Newedge USA’s fixed-income strategies group.

Eurodollars sold off last month as traders saw positive signals from employment figures, and traders began to consider that a broad economic recovery could be at hand, which could prompt the Fed to begin raising its benchmark rate from the current near-zero level.

“We’re unwinding some of that,” said Holland, who attributed some of Wednesday’s buying to mortgage-related hedging.

At the close of trade Wednesday, December-dated fed-funds futures priced in a 29% chance that the Fed would tighten the funds rate to 0.5% at the Dec. 15-16 Federal Open Markets Committee meeting, down from a 38% chance earlier this week.

Chicago Fed President Evans said Wednesday that the central bank is in no rush to raise rates, with the current rate of inflation at an “acceptable” level of near 2%.

  CONTRACT              SETTLE         CHANGE
   July    Fed Funds    99.815        Unchanged
   Aug     Fed Funds    99.805        Unchanged
   Nov     Fed Funds    99.735        Up 0.5 basis point*
   Dec     Fed Funds    99.71         Up 0.5 basis point
   Feb '10 Fed Funds    99.585        Up 0.5 basis point
   Sep     Eurodollars  99.455        Up 3.5 basis points
   Dec     Eurodollars  99.26         Up 6 basis points
   Mar '10 Eurodollars  99.085        Up 8.5 basis points
   Sep  10-Year Notes   118-20        Up 1 11/32
   Sep  30-Year Bonds   121-08        Up 1 26+/32
   * A basis point is equivalent to 1/100th of a percentage point.

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