Derivatives soon may overwhelm trading even in Treasury bonds


5:15p ET Monday, April 1, 2007

Dear Friend of GATA and Gold:

A week ago the Financial Times reported that an exchange-traded fund in credit derivatives was being started in Europe ( Now Bloomberg News Service reports in the story appended here that futures trading in U.S. government bonds soon may exceed trading in the bonds themselves on the Chicago Board of Trade -- because the futures allow investors far greater leverage.

This is Chapter Umpteen in the financialization of the United States, where hardly anybody makes anything anymore, where the economy is mostly one big service charge.

Speaking Friday night in Hartford, Connecticut, the political agitator Ralph Nader referred to the unprecedented level of financial speculation in the United States. Nader remarked that there would be no need to tax the income of Americans earning less than $100,000 per year and no need to tax the purchase of any ordinary necessities if the U.S. government applied a 1 percent sales tax to futures and derivatives trading.

But maybe these days the full faith and credit of the United States aren't as trustworthy as the full faith and credit of the Chicago Board of Trade.

CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.

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Futures to Surpass Bonds
As Appetite for Risk Rises

By Elizabeth Stanton
Bloomberg News Service
Monday, April 2, 2007

NEW YORK -- Treasury futures, the most active contracts on the Chicago Board of Trade, may surpass trading in notes and bonds for the first time next year as money managers use more derivatives to boost returns.

A record 60.5 million contracts changed hands in February, the equivalent of $6.62 trillion of Treasuries. Wall Street's biggest firms handled about $9.57 trillion of bonds, according to Federal Reserve data. Futures more than doubled in the past five years and, at the current pace, will overtake trading in the cash securities during 2008.

"Fund sponsors who had in the past not allowed investment managers to use derivatives are more eager to do so," said Greg DeForrest, senior vice president at Callan Associates in San Francisco. The second-biggest adviser to U.S. pension funds has about 266 clients with a combined $1 trillion of assets.

Almost all of Mellon Capital Management's customers for global asset-allocation products allow the money manager to use derivatives, up from 64 percent of assets in 2003 and 10 percent in 1999, spokesman Mike Dunn said. The San Francisco-based company is buying futures, providing more cash for investments in stock, bond, and currency derivatives.

Mellon clients that used futures got returns that averaged 17.3 percent a year between 1989 and 2005, compared with 13.7 percent for those who didn't, according to a review by Chief Executive Officer Charles Jacklin. Mellon managed $32.9 billion in so-called tactical asset-allocation funds as of the end of 2006.

Efforts to boost returns "have really made futures much more valuable than cash bonds," said William Hoskins, Mellon's director of fixed-income research. Futures costing $500 to $1,485 allow investors to capture price changes on $100,000 of underlying five- to 30-year Treasuries or $200,000 of two-year notes.

A survey by Russell Investment Group, the largest adviser to U.S. pension funds, found 87 percent of its clients allow money managers they hire to use derivatives. While there wasn't an earlier survey, "anecdotally my sense is it's increased," said Jeff Hussey, head of U.S. fixed income at Russell in Tacoma, Washington.

"Fixed-income managers are catching up to what hedge funds have to offer," said Hussey. More managers are aiming, with the aid of derivatives, to beat a benchmark by 2 percentage points annually, double the typical objective, he said.

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies, and commodities, or linked to specific events such as changes in interest rates or the weather.

Low bond yields are encouraging pension funds and other investors to take more risks in order to meet their targets for returns, Hussey said.

The yield on the 4 5/8 percent Treasury note due in February 2017 rose 0.03 percentage point last week to 4.65 percent. The price of the securities fell 1/4, or $2.50 per $1,000 face amount, to 99 26/32.

The yield on benchmark 10-year notes, which averaged 6.7 percent during the 1990s, hasn't been higher than 6 percent since August 2000.

Corporate bond yields also are low by historical standards. For investment-grade debt, the average yield is about 93 basis points higher than the comparable Treasury yield, according to Merrill Lynch & Co. It's been lower than 100 basis points since December 2003, after averaging 168 the previous three years.

Treasury futures contracts, introduced by the Board of Trade in 1977, require buyers and sellers to receive or deliver securities on a specific future date.

The average daily volume in Treasury futures listed on the Board of Trade in February was a record 3,184,429, equal to underlying securities worth $348.3 billion, according to the exchange. The amount is almost 37 percent higher than a year earlier. The 21 primary U.S. government securities dealers that underwrite Treasury auctions handled an average of $503.7 billion during the month, a 0.4 percent increase from the previous February.

Ten-year U.S. note futures are the biggest contract traded on the Board of Trade. Transaction fees from interest-rate agreements totaled $345.9 million last year, accounting for 56 percent of the exchange's revenue. Fees from all products accounted for 77 percent of revenue.

The Board of Trade's pending $8.9 billion acquisition by the Chicago Mercantile Exchange was topped by an unsolicited $9.9 billion offer by Intercontinental Exchange Inc. on March 15. The Merc lists Eurodollar futures, the world's biggest futures contract.

"It's a very important portfolio management tool," said Michael Materasso, senior portfolio manager in New York for Franklin Templeton Investments Inc., which oversees $124 billion. He has increased his use of Treasuries futures by about 20 percent in the past year after implementing strategies that compete with hedge funds. Franklin Templeton sells futures to reduce the interest-rate risk in corporate bonds.

While futures don't produce income like bonds, they are faster and easier to trade. More than 90 percent of Treasury futures change hands electronically.

"Futures offer a degree of anonymity to customers and allow them to meet their fiduciary obligation to get the best price," said Brian Varga, co-head of U.S. Treasury trading at Countrywide Securities Corp. in Calabasas, California.

Trading by the primary dealers, including Countrywide, fell last year for the first time in central bank data going back to 2001. After 17 interest-rate increases by the Fed pushed financing rates higher than Treasury yields and depressed volatility, investors found fewer opportunities to trade.

"Derivatives is the place to be right now," said Jim Bianco, president of Bianco Reseach LLC in Chicago. "It's a booming business, and so is the futures exchange."

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