Last week the Fed did two important things in its FOMC announcement. First the reference to risks from overseas turmoil was substantially watered down. The FOMC dropped the September phrase that global developments “…may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term” and instead simply said the Committee is “…monitoring global economic and financial developments.” Second, the announcement specifically referenced the “next meeting” (on December 16) for a possible rate hike. Interest rate futures responded by selling off, with the curve flattening slightly. For example, the ten year treasury yielded 204 on Oct 27 (the day prior to the FOMC) and yesterday closed just above 221. However, it has been so long since a hike, and Fed communications have been so muddled, that near Eurodollar and Fed Fund contracts only shifted to odds of about 50/50 in terms of a 25 bp hike at the December meeting. I personally think the market should have moved the odds to about 70% which would have put EDZ5 somewhere around 9953 or 9954, rather than 9959 which is the current price.
Today (Wednesday) Janet Yellen addresses the House Committee on Financial Services at 10:00 EST, and will be followed by the two other heavyweights: NY Fed President William Dudley speaks at 2:30 and Vice Chair Stanley Fischer speaks at 6:00pm to the National Economists Club. If the Fed wants to clarify its message and signal an initial rate hike in December, today is the day to do it. Labor markets justify a hike, inflation data doesn’t (as yet) which leaves financial stability concerns as a swing vote. Emerging market currencies and the stock market appear to have shrugged off concerns about a Fed move, allowing a clear window to hammer home the message.
What does the Eurodollar curve signal? The last rate hike cycle was way back in 2004 and went for two years. In June 2004 the FF overnight target was 1.00%. By the end of June in 2006, the overnight target reached 5.25%. The Fed tightened by 25 bps at every single FOMC meeting in that interim (there are 8 meetings a year).
As is my habit, I examine the one year Eurodollar calendar spreads for clues about market perceptions. First, let’s go back to 2004, just before the tightening cycle commenced. I reviewed the second quarterly Eurodollar contract versus the 6th quarterly contract on a rolling basis. As I have mentioned previously, I use the one-year spread for a proxy of how much the market perceives the central bank to hike in a given year. It’s interesting to note that this spread reached 191 basis points in May 2004, a pretty accurate foreshadowing of the actual amount of tightening (200 bps per year). As the actual tightening occurred, the rolling one year spread began to decline. By October of 2014, the 2nd to 6th contract had declined to just below 100 bps. So as the actual tightening got underway, the market scaled back the future potential hiking, and in this sense, underestimated the Fed.
Since the middle of October, the current one-year calendar spreads have widened. For example, the current 2nd to 6th quarterly is March 2016 to March 2017. It is the peak one year spread on the curve and popped up to 62 bps as of Monday, a new recent high (EDH6 99.44 and EDH7 98.82). On a rolling basis, in the middle of 2015, the one year spread traded 80 to 90 bps. So in this case, the market is embracing the Fed’s repeated assertions that tightening will be gradual, perhaps two or three 25 bp moves in a year. I had been in the camp that the Fed would not move this year, but the October statement changed my outlook. Today’s speeches will be key. However, remember this: the Fed will definitely not become aggressive in its hiking campaign over the near future. Trade accordingly.
