Inflation, or the anticipation of it, has been on people’s minds after the actions taken by global policymakers to shore up the financial system over the past two years. I will discuss the relationship between inflation, the U.S. dollar, interest rates and commodities, and discuss how you might use Eurodollar futures to trade inflation expectations.
Why discuss inflation? Inflation seems like a likely result of the actions the Federal Reserve has taken to pump liquidity into the market. The Fed has lowered their target lending rate, known as the Federal funds rate, to near zero. (The Fed funds rate is the overnight lending rate between banks.) To lower this target rate, the Fed increases money supply to encourage banks to lend more money. The more money that’s in the system, the lower interest rates are. The Fed also has increased money supply by buying distressed assets, as well as loaning directly to banks. Once all this money gets put to use, what typically results is inflation. The increase in the supply of money increases the cost of goods throughout the economy. However, just adding money to the system doesn’t necessarily cause inflation. If you bury the extra money in your back yard, it’s not in the system. You have to start spending it. Once consumers feel better about the economy they will start spending; that money will be in circulation and will then be reflected in prices.
To combat inflation, the Fed can reverse course. They can raise their target interest rate, and take money out of the system. People will be more encouraged to save at higher interest rates, and less likely to take loans out and pay higher rates.
The U.S. Dollar and Commodity Inflation
When you discuss the value of the dollar, you have to remember its value is relative to a particular currency. For example, at current exchange rates, if I gave you one euro, you would owe me about $1.48 in U.S. currency. With my one euro, I can then buy $1.48 in U.S. goods. Last May, I could only buy $1.30 worth with my one euro. The euro is getting stronger, so I can buy more U.S. goods now than a few months ago. The U.S. Dollar Index, traded at ICE Futures, represents the dollar’s standing against a basket of six global currencies. That’s usually what people refer to when talking about the value of “the dollar” in general.
So far, the economic data has not shown inflation to be an issue. The producer price index (PPI), which measures prices at the wholesale level, and the consumer price index (CPI), which measures prices at the consumer level, have been pretty tame. Although it’s not a problem today, investors are anticipating inflation.
The low U.S. interest rates have encouraged what’s called the carry trade. The carry trade occurs when investors borrow in one currency, convert it to another, then invest in a higher-yielding foreign asset. The money may be invested in foreign bonds or even put in a foreign bank account yielding a higher interest rate. So the carry trade is essentially capitalizing on the interest rate differential between different countries. You are borrowing dollars, then selling and exchanging them for foreign currency. As you sell these dollars, you are decreasing the value of the dollar, just like any commodity would increase or decrease in price based on typical supply and demand factors. The carry trade has helped pull down the value of the dollar.
Now that these overseas buyers are seeing their currencies increase, they can buy more products denominated in U.S. dollars. As the demand in dollar-dominated commodities increases, that causes prices to rise. You can see that trend in commodities such as corn, crude oil and gold, which have all been rising as the dollar has weakened. Gold is viewed as traditional inflation hedge as a store of value as well. When overseas buyers can buy gold at better prices, they will typically buy more of it.
U.S. Dollar Index
Gold
Eurodollar Futures and Inflation Expectations
So that’s how inflation works in the context of a falling dollar and rising commodity prices. One way to play these economic trends is in the interest rate futures markets, including 30-year Treasury bonds, or 10-year Treasury notes.
Keep in mind that prices in bonds and notes trade inversely to yields. A par of 100 for a 30-year bond represents a coupon rate of 5 percent. That’s a standard government-issued rate. However, the cost of a bond is determined by market forces, and the face value will change as interest rates change in the marketplace. If prevailing rates are anticipated to be less than 5 percent, that 5 percent coupon looks attractive and the price of the bond will be higher than 100. If interest rates are anticipated to rise above 5 percent, that old 5 percent bond doesn’t seem as attractive, so you would get a discount and the value of the bond would be priced under 100. Thus, when rates go down, prices go up. December bond futures are trading above par, currently near at 117. That represents the low interest rate environment we are in, although translating the futures bond’s price into the equivalent cash yield can be complicated.
Eurodollar futures are one of the most actively traded contracts in the world and are perhaps a better vehicle to speculate on rate changes and inflation. These are three-month contracts that represent the interest paid on $1 million deposited overseas. One of the primary benefit of trading the Eurodollar contract to anticipate inflation and interest rate hikes is that it’s more closely aligned with the Fed’s target rate than bonds or notes. The 30-year bond represents a long-term lending rate, and might not be affected the same way when the Fed makes a rate change. Interest rates generally move in the same direction along the yield curve, but don’t have to, and don’t always. The 30-year lending rate isn’t the same as the overnight, Fed funds lending rate, but the Eurodollar rate is very close in line.
With Eurodollar futures, you can figure out the equivalent yield very easily based on the price of the contract. The December 2009 Eurodollar contract is trading at about 99.65 currently. Subtract that from 100, and you get 0.35 percent. That’s the interest rate the market expects you would expect get on a $1 million deposit overseas in December of this year.
Eurodollar futures prices can also easily tell you where the market thinks rates are headed farther out in time. March 2010 Eurodollars are priced at 99.405, anticipating a rate of about 0.60 percent. December 2010 is priced at 98.19, anticipating 1.8 percent on that $1 million deposit, and December 2011 is pricing in rates just above 3 percent. You can see what’s built in, quickly and easily. Each move of one tick is worth $25, for example, from 99.65 to 99.66. CME Group does offer a Federal funds futures contract as well, but the institutions like trading the Eurodollar, and it has far more liquidity. People are comfortable with it, and it’s been around for a while. You can also trade Eurodollar options.
You as a trader have to decide when, and how fast you think the Fed will raise or lower rates, and how the Eurodollar contract will react. Over the past month and a half, there hasn’t been much movement in this contract, as no one really anticipates much of a change. But the uncertainly is higher further out in time, so you see more swings in the back-dated contracts.
I think the Fed will act aggressively to try and curb inflation, but I don’t see it happening until perhaps spring of next year. Speculating on inflation, and the timing and rate of Fed actions will offer interest rate and commodity traders many interesting opportunities in the year ahead.
Feel free to contact me with any questions you might have about options or futures trading, and how to incorporate some of these concepts into specific trading strategies in the markets today.
Matt Krupski is a Senior Market Strategist with Lind Plus. He can be reached at 877-847-3034 or via email at mkrupski@lind-waldock.com. Follow Matt on Twitter at www.twitter.com/LWMKrupski.
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