There are so many wacky things going on with Eurodollar futures, from libor blowing out to Kong buying EDZ8-Z9 in unprecedented sizes, that it’s hard to get a good handle on what is going on with short end interest rates just from looking at the EDs. I haven’t seen the ED curve this messed up since the Libor crisis a decade ago. But this time around, the economy is perfectly fine! EDs are insane!!!
Fortunately, we have Fed Funds, which gives us a cleaner look. But even that has a little noise in it from the markets pricing in a chance of a higher than 1.77 Fed Funds Effective Rate after a March hike. That should just result in a parallel move on the FF curve, so the rest of the curve should have some useful information.
The second column (table on the right) shows how many bps of hikes are priced into the FF curve. The quarterly meetings are highlighted in yellow. The pricing for this year seems somewhat reasonable. There are three things that stand out to me on this table:
- The positive fly structure still holds in FFs. That is, the front 3mo and 6mo flies are the highest in the front and lower in the back. So while the front flies in EDs are negative, this is purely a function of Libor.
- H1 2019 hikes. Thanks to Kong (the EDZ8-Z9 buyer), we have the H1 2019 meetings being priced almost as much as the Dec 2018 meeting. That doesn’t make sense to me. Part of it seems to be unusually large selling in FFN9. Keep in mind that the Republicans have lost every major election since Trump’s victory. As I mentioned a while back, it seems likely that the Democrats will win back the House later this year. And when the Dems get into power, we will have two things: (1) gridlock on new legislation, and (2) chatter about Trump impeachment proceedings commencing. It’s highly unlikely Trump will get impeached, but you can be sure things will start moving in that direction. While things look rosy now, I’m not so sure things couldn’t change in 2019, with a Democratic House.
- Severe inversion of the ED vs FF curve. Consider that the EDH8-M8 spread has 47% of the May meeting, 92% of the June meeting and 53% of the August meeting. So the EDH8-M8 spread should be worth 18.4bps, if the ED-FF curve was completely flat. But it is only 10.5bps (or a difference of 7.9 bps to comparable FFs). The table above (in the last column) just shows the simple ED spread and quarterly FF meeting spread differentials. The table shows a close enough approximation, as it is showing -7.3bps (this is because the non-quarterly meetings are relatively small). Having EDH8-M8 be inverted to FFs is reasonable if you believe that the libor-FF widening is a “Fed T-Bill issuance before April 16” story. You would expect to see the most ED-FF narrowing between EDJ8-FF and EDK8-FF. What is strange however, is that EDM8-U8 is about -5.0bps flatter, signaling that the market thinks Libor-FF will narrow another ~5bps between mid-June and mid-September. I tend to think either we have normalized by mid-year, or we will be in a new libor regime where libor-FF will just remain wide.
As for the Fed meeting and statement, I don’t think the Fed’s message is going to change much. They will hike 25bps and taper their repurchases (again). They have to be very pleased with how the economy, rate normalization and balance sheet normalization are going, and I don’t see them rocking the boat in any way.
The dots are supposed to be higher. For the 2018 dot to change, we would need three of the six 2.125 dots to rise. That’s a close call, as you would expect a few more people to price in a chance of a fourth hike. But I would think a higher 2018 dot would be a < 50% proposition. For the 2019 dot to increase, we only need the 2.75 dot to move up or for one of the two 2.625 dots to move. That’s not much of a hurdle, considering the better growth prospects since December. This may be one of the reasons for the EDZ8-Z9 buying. Let’s see to what extent an “unchanged 2018 dot and a higher 2019 dot” gets priced in going into the meeting. I would think we could get a partial unwind of positioning after the fact (FOMC meeting). We should also expect the bulls to step aside ahead of the Fed meeting and come back in afterwards, all other things being equal.
The press conference should be extra-interesting because this is Powell’s first as the new Fed Chair. The three things I’ll be looking for are:
- Powell’s thoughts on trade tariffs. This is the new major twist to economic prospects that have come up since his Congressional testimony.
- If Powell says anything about Libor. I’m not a conspiracist, but Mnuchin can’t be happy about paying extra for short term financing. The Fed does have swap/liquidity lines with other central banks. I’m wondering if some action may be discussed – the Fed staff does discuss financial conditions at every meeting.
- Whether Powell addresses the issue of having a press conference at every meeting. I’m thinking the nonquarterlies could take a dip if there is no mention of this, and there is no other suggestion of a nonquarterly move (other than the usual “every meeting is live” comment). If he was going to switch the press conference structure, I think he would let us know at his first meeting as Chair.
We could get some volatility, so let’s look for trading opportunities around then. Stay tuned.
 Year-end turn adjusted, using 1.25bps.