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How & Why Treasuries Matter to FX Traders

By , Forex Trading Instructor
10 April 2012 07:00 GMT

In our last article, we looked at the history of Treasuries, and how US Treasury instruments began to be considered one of the ‘safest investments in the world.’

In this article we’re going to get more in-depth with the structure of these important assets, and how they are traded; and even more importantly, we’re going to lead in to how Forex traders can use Treasuries to gleam directional biases in the markets, assisting with everything from short-term scalping, to long-term position trading.

The Structure of Treasuries

There are quite a few different flavors of US Treasuries. The Treasury bill, dubbed the ‘T-Bill,’ is the shortest-term variety; often issued at 90 days but the term ‘T-Bill’ pertains to all Treasury debt issues of less than 1 year. Due to this short-term maturity, and the fact that the United States government has never default on a dollar of debt; this is often considered the ‘risk-free’ rate of return.

Types of Common U.S. Treasuries

Maturity

How Interest is Paid

Pricing

Bill

Less than 1 year

Zero Coupon (Matures at Par)

Discounted to mature at 'Par'

Note

Up to 10 years

Coupon

May be priced at premium or discount

Bond

Over 10 Years

Coupon

May be priced at premium or discount

Treasury Notes are debentures with maturity between 1-10 years; and Treasury Bonds have maturities longer than 10 years. Due to the fact that these bonds have longer maturities, the risk is seen as being slightly higher. Thus, the interest rate will often increase the longer the maturity is set out in the future. So as a generality, the longer the maturity, the higher the rate. This forms the ‘Yield Curve’ that will be covered in the next installment to the series.

Each week the Treasury Department holds public auctions for new debt. The maturities that are being sold will differ, but the Bill will be one of the issues sold at each auction as this is sold to cover short-term expenses.

The Pricing of Treasuries

The first thing that traders need to learn about Treasury bonds (and most bonds for that matter), is that price and yield move inversely. If investors are bearish, and sell bonds – we will see yields increasing. This can happen for a number of reasons: Perhaps investors would rather invest in stocks to look for a higher return; or maybe the credit quality of the issuer has come into question and traders look for other bonds (with fewer questions on the issuer’s ability to pay interest).

Treasury Bills are always sold as a ‘zero-coupon’ bond – which means simply that the bond is sold at a value of less than ‘par,’ commonly $1,000 per unit, and when the maturity comes due – the investor gets the full $1,000 to compensate for the initial purchase price, as well as the interest owed.

For example, if I buy a 6 month Treasury Bill at 97 today, that would mean I paid 97% of the par value of the bond; which would mature at $1,000 in 6 months. So I paid $970 today, and will receive $1,000 in 6 months, for a return of $30, or 3%. But this was only for 6 months, so I would be looking at an annualized rate of return of 6%, assuming no compounding.

Sound confusing? Don’t worry – this is confusing to almost every new bond trader, or investor. When this begins to make sense is when we see how traders around the world price these important bond issues, regardless of how long they have until maturity.

Treasury Bills are always sold as a ‘zero-coupon’ bond – which means simply that the bond is sold at a value of less than 100.00, and when the maturity comes due – the investor gets 100 to compensate for the initial purchase price, as well as the interest owed.

Notes and Bonds differ from the issuance of Bills; as both will generally carry a coupon (rate of interest on the ‘par value’ of $1,000 per bond) based on prevailing market interest rates. The Treasury will then announce the coupons ahead of the auction, and investors can decide how much they are willing to pay for the bond.

If the treasury is paying higher than normal rates, investors will usually ‘bid’ these bonds higher; meaning they will drive the price over par, at say 101, or 102.

Returns on Zero Coupons v/s Coupon Bonds

Zero-Coupon Bond

Coupon Bond

Interest Payments

None

Yes, at 'Coupon Rate'

Pricing

Discount (Matures at Par)

Premium or Discount

Interest Payments

Time to maturity

Based on Coupon Rate

At maturity

Matures at par

Matures at par

After the initial auction, Treasuries are traded in one of the most active secondary markets in the world; with investors around the globe buying and selling treasuries for speculation, investment, and safe-keeping.

The Secondary Market

The secondary market for treasuries is where the rates for all of the above issues are decided.

If the US reports surprising, disappointing economic numbers – investors around the world will often panic (to some degree - the degree of which will often be determined by the degree of the ‘surprise’).

If positive news is announced, investors fear missing out on a bigger return in markets such as stocks, so they sell their low-yielding treasuries to use their capital in search of bigger returns elsewhere.

How does this affect the FX Trader?

Well, if an investor is buying treasuries – what currency do you think they need in order to buy them?

That’s right – US Dollars; and this is precisely the reason that traders in the FX Market may see massive strength in USD during a ‘risk-off,’ campaign.

Investors – fearing for the safety of their capital – will often think – ‘what good is a return on my principal if I’m losing my principal faster than I’m accruing interest?’

If you are in an investment that is earning 10%, but you lose 15% on the capital – what was the point in the bigger return in the first place?

You are exactly right – there is no point. And this is exactly why investors will ‘flock-to-safety,’ during times of bearishness in markets. This can also be called a ‘safe-haven run,’ as investors are ‘running’ towards the ‘safe-haven’ of the US Dollar.

The following table walks through the effect of ‘risk-on,’ or ‘risk-off,’ for traders in the FX market:

Risk-On

Risk-Off

General view on Treasuries

Bearish

Bullish

What does this mean?

Investors greedy

Investors scared

Investor priority

Highest Return

Safety

Commonly desired currencies

AUD,NZD,GBP,EUR,CAD

USD,JPY,CHF

Desired FX Strategies

Carry Trade, Trend systems

Breakouts, 'flight-to'quality'

And for an investor looking for safety, few assets on the face of the Planet Earth can offer what United States Treasuries and the United States Dollar can present to investors, and traders around the world.

For more information on ‘why’ the US Dollar, and further, the US Treasury is the safest asset in the world, our previous article looking at the history of US debt will offer more information.

In our next installment, we will look at various ways that traders can use interest rates changes of Treasuries to denominate their strategy approach in the Forex Market.

--- Written by James B. Stanley

To contact James Stanley, please email Instructor@DailyFX.Com. You can follow James on Twitter @JStanleyFX.

To join James Stanley’s distribution list, please click here.

Treasuries Part 1 – A History of US Debt

How a Currency Can Change the World

How to Manage the Emotions of Trading

Money Management module -- On-Demand Trading Course

“What is the Number One Mistake Forex Traders Make?”

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10 April 2012 07:00 GMT