Today Yellen testified before Congress in her semi-annual testimony. Last week, prior to the FOMC meeting, I wrote, “…though some Fed officials have vocally called for rate hikes, Yellen is likely to adopt a cautious stand for the foreseeable future. The Fed’s risk management model is such that it weighs the costs/benefits of staying put versus raising.” Indeed Yellen was cautious in her testimony, and voiced concern about deceleration in labor markets. The Eurodollar curve was already signaling this caution; as I have noted previously, the one-year calendar spreads are a reasonable proxy for how many Fed hikes might occur over a given year. If we assume the Fed moves in ¼% increments, then a spread like Sept’16 to Sept’17 (EDU16/EDU17) would be around 50bps if the market expected two Fed moves in a year. If the spread were 100 bps, it would indicate market expectations of four hikes a year. I am not saying these market signals are necessarily “right”, I am just saying that the market sometimes forecasts a different signal than the Fed.
Currently, all the one year Eurodollar spreads are below 25 bps. Since February of this year, EDU16/EDU17 has been between 13 and 34 bps. It settled Tuesday at 23.5. So, the market is looking for one hike. In fact, there are NO one year spreads currently trading over 25 bps. When the Fed chair says the Fed is expected to move gradually, the market is on the same page, and might even modify the characterization to ‘glacially’.
Currently of course, the Brexit issue is the dominant focus of the market. This topic has broadened out to whether the Eurozone itself will survive, and has given rise to various alternative ‘safety’ trades. Some of these trades are also a result of eroding confidence in central banks. For example, bitcoin exploded over the last month from around 450 to over 650 currently, and gold, though down yesterday, is still up 20% on the year. The point is that central banking authorities globally have a lot on their plates, and are loathe to stifle monetary accommodation given uncertainties. If the monetary authorities are perceived by the market as being TOO accommodative, then more deferred Eurodollar calendar spreads will start to widen, for example from the second year out to the third year out contracts. If this occurs, then one could conceivably say the Fed is ‘behind the curve’. For now, that’s NOT the case.
Alex Manzara
