Interest rates are easily traded and are a subject on which many investors have strong views. There are several ways of trading on the future movement of interest rates and it is a fascinating time in the market at the moment, with a fair bit of uncertainty about the timing of any future interest rate move. But are they worth betting on? Alex Sawyer from ETX Capital thinks they can be. 'During recent years, the central banks have been very open with their interest rate policies,' he says. 'This has led to the usual interest rate markets such as short sterling and Euribor being fairly static.
However, the recent rate rises in the UK and the lack of clear direction from the Monetary Policy Committee has led to more volatility. With March short sterling currently trading at 94.65, there are certainly mixed feelings as to whether there is another rise in the offing.' The uncertainty is good news for traders looking to profit from any potential move.
There are several ways of betting on interest rate movements. 'Finspreads offers contracts on all the major interest rate markets, including eurodollar, euribor and short sterling,' says the company's market strategist, Angus Campbell.
Traders new to the interest rate market need to bear in mind that it works slightly differently from the equity market. Campbell continues, 'The most important thing to know when trading interest rate futures is that if you expect interest rates to fall in the coming months, you must buy the interest rate future. If you believe interest rates will rise, you must sell. The reason for this is so that their inverse relationship reflects the movement of the bond market. Generally, if interest rates rise, then bond prices fall and vice versa.'
The reason behind the inverse relationship between interest rates and bonds is investor behaviour - if interest rates rise, investors will sell the bond they hold to buy other higher-yielding assets. Conversely, if interest rates fall, the higher-yielding bonds become more attractive, so investors buy them, driving their price up.
Virtually all markets are affected by interest rate movement. It's something all traders should watch out for, as it can have a distorting effect on otherwise sound trading strategies. 'Traders can always look to currency markets, bonds and stock indices. The unexpected rise in August knocked 100 points of the FTSE, 90 ticks off the gilts and added 2 cents to the value of the pound,' points out Sawyer of ETX Capital. He also has some very good advice on timing interest rate trading decisions, 'If the central banks, especially the US, continue to be as open with their plans, there will be more volatility when minutes of meetings are released rather than on the rate announcements themselves.'
There are two elements to the value of a bond. There's the price and the yield. Bonds are issued, in the case of gilts, by the government at a par value of £100. They will pay an interest rate known as the coupon. The coupon will depend on the level of prevailing interest rates when the bond is issued. If the coupon is 6% then each £100 bond will pay £6 per year. After the gilt has been issued, the price of the bond will change to reflect the prevailing level of interest at the time.
In the example above, if interest rates fell, the bond would continue to pay £6 per year and its price would increase to above £100, so that the yearly yield would be in line with the lower interest rates. Bond prices are, therefore, inversely proportional to bond yields.
As the price rises, the yield falls. The pricing of bonds is very complex. They are very sensitive to inflation, supply and demand and underlying interest rates. That said, the simple inverse relation to interest rates and anticipated interest rates stands. So if the expectation is that interest rates are likely to fall, a trader would go long (buy the bond) and sell if interest rates are likely to rise.
Watching the price movement of bonds will give an idea of how the market anticipates future interest rate moves. It's also a reasonably good way to bet on forthcoming interest rate decisions. However, due to the other factors affecting bond prices, they can be something of a blunt instrument when betting on the future movement of interest rates.
Another way of gaining access to the interest rate market is through an instrument called short sterling. Short sterling futures indicate the interest rate expectation at certain points in the future. Their price is directly determined by interest rates and is calculated by subtracting the current interest rate from 100. So if March short sterling is trading at 95.63, the market is predicting interest rates in March will be 4.37% (100-95.63).
To trade this market, check your spread betting company's March short sterling quote. Let's say it is 95.62-95.66 - the spread betting company is predicting interest rates will be 4.34%- 4.38% in March. Thinking that interest rates will fall, you decide to buy the short sterling contract. You buy at 95.66 for £10 pounds a point (0.01). When you decide to close your position after a cut in base rates by the Bank of England, the March contract is trading at 95.76- 95.80 - implying an interest rate of 4.20%-4.24%. You sell £10 per point for a profit of £100.
It is important to remember that the value of the short sterling contract doesn't just change when the Bank of England changes its rates. The price of the contract is always changing. It reflects the market's view of what is going to happen to interest rates at some time in the future. As news and economic numbers are released, the market will change its mind on what the interest rates will be. At the time of writing, base rates stand at 4.5%, the January three-month short sterling contract is trading at 95.41, implying an interest rate of 4.59%. The market believes there is a small chance interest rates will rise in the next three months.
Sometimes the spread betting companies will create a market of their own for interest rates. This provides another way of betting on the outcome of the MPC meeting. This market doesn't really exist on any financial exchange. Often the spread betting companies will make this market to generate positive PR and press mentions on the day of the MPC meeting. Their prices and the company name will be quoted in the financial papers.
The currency markets provide another way of betting on the movements in interest rates. When interest rates rise in a particular currency, that currency tends to rise too. The currency becomes more attractive to investors because they can achieve a better income for their cash. The buying of the currency associated with an interest rate rise pushes the price up. However, there are exceptions to this, for example when sterling was pushed out of the European exchange rate mechanism, so it's important to be careful.
There's an interesting situation at the moment with sterling against the dollar. The dollar is fairly weak for a whole host of reasons. This, added to the uncertainty around the next move in UK interest rates, is helping to push sterling to record levels against the dollar. Many speculators will be looking to profit from an interest rate move by betting against the dollar.
So next time you log in to your spread betting account, remember there's a vast number of markets to trade. If your favourite equities are trading sideways, look for opportunities elsewhere. There's always a bull or bear market somewhere.
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