Novice Gap in the 30 Year Bond Futures?

ddawson 20150310 - rollover-gap

If there was ever a good example of a novice in the markets it would be the Governments of all the different countries in the World. Recent examples are: the move by the Swiss Government blindsiding the markets with their currency decision, China putting a cap on their Currency making an unfair trade imbalance with the rest of the world and, of course, who can forget the United States back in 2000 when our President declared we had such a surplus in our economy that we would never need long term debt again. Now I am not an Economist, but even I knew that was impossible back when that decision was made.

I had been trading the 30 year Bond market for about 13 years at that time and it pretty much killed one of the best trading markets in the world. If ever a market was perfect for buying dips and selling rallies it was the Bond Market. Prior to the announcement of discontinuing the 30 year Bond issuance by the Government, the 30 year Bond was the benchmark interest vehicle in the United States. Very good volume and excellent price fills even when you traded off the floor and had to phone your orders into the pits.

As we all know, Countries around the world are now in need of long term debt again to bail out of this financial crisis we have been in for years. The situation has even provoked the CME Group to offer an Ultra Bond Futures contract with a maturity of 100 years. Wouldn’t it be nice if our Governments could learn from their mistakes like traders try and do?

Because the 30 year Bond market (@US=114XN) is a physically deliverable Futures contract, the suspension of issuance (2001 – 2006) has come back to haunt us traders when it comes to trading this product on a continuous Futures chart like we are accustomed to trading on.

Chart 1 shows the rollover gap last week when the March contract went into delivery notices on February 27 and the June contact became the new front month. You can see, the gap up on our continuous charts is approximately 15 handles (points). It will take a while for this gap to be filled.

Treasury prices move inversely to the yield of the Bond products. If prices are going up then yields are going down, if prices are going down then yields are going up. Each contract month of the Bond market (March, June, September, December) has a different price. These are based on the cheapest to deliver cash Bond. Since the Bond Futures market is a physically deliverable contract it is tied to this cheapest to deliver cash Bond that has been issued by the Government at one of their many auctions.

If an investor owned a Bond with a face value of $100,000 and the coupon rate was 6% and, after buying this Bond from the Government the coupon rate dropped to 5%, the investor would have capital appreciation and interest rate income. That’s because the 6% Bond is worth more because the yield went down but the price went up. If a new investor wanted to buy the 5% Bond at an auction then he would just pay the same $100,000 face value; but if he wanted to buy the 6% Bond (to get higher interest rate income) from another investor he would have to pay $100,000 plus the difference in price between 5% and 6%. Buying cash Treasury products is another article all together.

Under normal circumstances the Government auctions these Bonds on a regular basis during the year, making each Bond Futures contract easy to deliver to the cheapest to deliver cash Bond with a maturity some 15 or more years down the road. All Futures are tied to a cash product and Treasuries are no different. However, when the auctions of 30 year Bonds were suspended between 2001 -2006 the Futures contracts kept trading and interest rates continued to change. Dealers were forced to deliver previously issued Bonds (prior to 2001) from older auctions they had acquired. The CME will accept for delivery Bonds with at least 15 years until maturity. Now that we are in the year 2015 we are starting to see the impact of these off-the-run Bonds being priced much higher than current Bond prices. An off-the-run Bond allows for delivery of a previously issued Bond and not necessarily a currently issued Bond. These two types of Bonds can have dramatically different prices, as we are seeing in the new June 2015 Bond Futures contract, simply because they were issued at different times, in some cases years apart.

From a trading standpoint we will have to make a decision which chart we wish to use for finding our trade setups. Our choices will be to use the continuous contract and deal with the gap, or perhaps use a contract specific chart. This would mean just trading USM15 charts. The main problem with these charts is they have very low volume prior to becoming the front month contract. So intra-day charts will appear to be very illiquid and have many intra-day gaps. The key will be to pick your chart and stay with it. You do not want to be using both types of charts because you will get conflicting signals.

This change will only impact the 30 year Bond contract and has nothing to do with other maturities. Perhaps a trader might just stop trading the 30 year for about 6 months, until the new charts have time to build enough significant and current data to trade from (just a thought). Think of this June 2015 contract as an “IPO” (initial public offering), not enough data to trade yet.

While this may sound complicated and confusing it is just part of staying abreast of the markets you are trading. I have said before that, “trading is a career where you never know it all” and, “do you ever stop learning to trade.” You must put the hard work in to reap the potential rewards. Just because something is called income generating does not mean it is easy money.

My personal quote I like is, “If you treat your trading like a hobby you will get paid like it is a hobby. If you treat trading like a business then you will get paid as if it is a business.

Don Dawson

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