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09 25 2015 | by Victor Xing | Capital Markets

Why is the 2-year Treasury note more sensitive to FED policy than T-bills?

Federal Reserve policies are indeed main drivers for very “front-end” or short maturity rates.

However, longer maturity Treasury notes such as 2 year note, 3 year note and 5 year note have other characteristics that make them more sensitive to FED policies

  1. Duration, or in bond investment terms, DV01 (dollar value at risk per 0.01% change in yield per $1mm notional invested).  2 year notes have a DV01 of approximately $170, 3 year notes around $270, 5 year notes approximately $480, etc.  Therefore, it becomes more efficient for investors to be long or short 2 year, 3 year, and 5 year notes.  If more investors are holding 2 year notes to express their views, then 2 year part of the curve would naturally be more volatile during major data or policy events (people caught on the wrong side of the trader would be trying to get out amid poor liquidity, causing price to gap in either direction)
  2. Express expectations of rate path.  Longer maturity Treasury notes also allow investors to price in path of future hikes, such as more hikes in the next 12 months.  Very front-end of the curve would be more sensitive to just “when” the next hike / cut will happen
  3. 3 to 5 year part of the curve tend to move the most.  Investors usually price in not only when the FED will hike rates / lower rates, but also whether the FOMC will hike more / less in the days ahead, and at what pace.  3 and 5 year notes have higher duration (higher interest rate sensitivity), as well as allowing investors to express their views on a sequence of policy decisions.  Therefore, it is my opinion that 3 to 5 year part of the curve is usually more sensitive to FED policy decisions.

Finally, regarding duration and ability to express views on FED’s rate path.  Investors also favor Eurodollar futures (where 3 month LIBOR rates will be at a given time in the future) and FED Funds futures (where average Federal Funds rate would be at a given time in the future), because they are leveraged and allow investors to express views across specific time frames in the future.

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