Interest rates are the most important financial measure for the global financial system. All financial markets and businesses are dependent on interest rates. High interest rates increase the cost of doing business and force many businesses that are highly leveraged into bankruptcy. Low interest rates help the economy as well as the business grow. Now, one of the ways to profit from the increase or decrease in interest rates is by trading interest rate futures. Most popular are the Eurodollars and and the Treasury Bills, Notes and Bonds.
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As a futures trader, US Treasury Bonds Futures should be very important for you. However, in this decade the European Bond Market and the bond markets in China and Dubai are going to play increasingly significant roles. So the bond market is at the center of the financial world. At the center of the bond market is the US Federal Reserve (FED) and the way it raises and lowers the interest rates.
Now, as a trader and as an investor, you need to understand how the bond market, the rest of the financial market, the FED and the interest rate changes work out. This understanding can help you in your trading and investing endeavors.
FED has the power to increase or decrease the interest rates in the US economy. Now, everyone knows this. FED has got basically two policy instruments that it can use to achieve its policy objectives. The first one is the setting of the FED FUND RATE. FED FUND RATE is the overnight lending rate in the commercial bank market that the banks charge each other for meeting the stipulated reserve requirements set by FED. So FED can increase or decrease this rate at its discretion. This is a short term interest rate as you might have imagines that is simply the overnight rate. But it has the potential of setting a chain reaction in the economy that than changes the medium as well as the long term interest rates in the economy. The second policy instrument at the discretion of the FED is the Discount Rate Window. This facility is only offered to banks that are facing insolvency problems by giving them cheap loans at least cheaper than the market.
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Now how does the FED FUND RATE trickles down through the rest of the economy. Let's see how it works. Suppose, FED is worried about the overheating of the economy and the rise in inflation. One of the primary jobs of the FED is to control inflation in the economy. So, the FOMC decides to increase the FED FUND RATE. This increase forces the banks and the credit card companies to increase their prime rates that they charge their best customers. Now, when bond traders sense an increase in the interest rates, they start selling their bonds in the market. This increases the market interest rates further. Auto loans and the home equity plus mortgage loans are tied with these bond benchmark rates, so they increase as well. So, you can see, how a chain reaction develops in the economy. This increase trickles down through the economy with a time lag that might be as long as from six months to more than one year.
Now the most important interest rate futures are the FED Fund Futures. These futures contracts get traded on the Chicago Mercantile Exchange (CME) and are a pure bet on what the FED is expected to do with the interest rates. The second most popular interest rate futures are the LIBOR Futures. This futures contract is based on the London Interbank Offer Rate (LIBOR) the rate charged between commercial banks. EUROYEN deposits are also popular!
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