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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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The trade in fashion if you're feeling a bit hawkish ..... and just in case, one if you're not. ref :- "Bond Market's Hot Trade Is a Cheap Bet Fed Will Keep Its Promises" , Bloomberg Markets

December 14, 2017



To the surprise of absolutely nobody, the Fed duly hiked rates by 25 basis points yesterday. In doing so they came through with what their forward guidance had long been suggesting ..... a total of three rate hikes in 2017. Well done them ..... if you take the market's expectations of what would transpire, as implied by prices in Fed Funds futures contracts, then plainly a good many investors spent long periods of 2017 doubting that the central bank would be able to fulfil their promises. For them, lacklustre inflation numbers would undermine the Fed's intention to get three hikes in during the calendar year. Well, low inflation numbers are still an issue but by taking a certain amount on trust the Fed have managed to make good on their call.


Much the same thing is going on when it comes to expectations for 2018 and beyond ..... which is why what the Fed had to say about the future was always going to be of more interest than yesterday's universally anticipated rate rise. Once again, the Fed is pointing us towards three hikes in 2018 whereas market prices imply that just two are more likely, and once again it's largely the low inflation factor that's dampening expectations.


It's a little strange ..... the market expectations do not seem to reflect a growing element of more hawkish investors  --  perhaps they're just getting a bit noisier about it. Whatever the case, some were eagerly awaiting Fed Chair Janet Yellen's post-FOMC press conference (her last, incidentally) to see if she would open up the possibility of FOUR rate rises next year. If you buy into the theory of already respectable growth data being further boosted by the new tax plan and inflation finally rousing itself in the face of ever lower unemployment numbers, it's a perfectly plausible scenario. In the event, Ms Yellen stuck with the existing prognosis  --  three hikes in 2018 and two more in 2019.


That won't stop hawkish speculation one bit of course  --  especially as those of that frame of mind are already taking advantage of the market consistently underpricing the likelihood of the Fed's future monetary policy matching up to its rhetoric (or forward guidance) as it stands.


Take a look at the action in Eurodollar futures ...... 


( For the uninitiated, and apologies to those for whom this is all a bit ABC .... : Eurodollar contracts represent expectations for the interest rate of a 3-month interbank deposit, and very simply are priced as the interest rate taken away from 100. So, if the expectation is that 3-month interbank deposits will be trading at 3.00% say, the price of the Eurodollar futures contract would be 100.00  -  3.00  =  97.00)


Now, for obvious reasons the Eurodollar futures market is hyper-sensitive to Fed policy. Market scepticism that the Fed will deliver not just in 2018 but also beyond means that the spread between the price of December 2018 Eurodollar Futures and the December 2019 contract is just 18 points. In other words, the market price tells us that 3-month Eurodollar interest rates will be just 18 basis points higher in Dec 2019 than it will be a year earlier. This is very close to it's 2017 low and is pretty much writing off the chances of a hawkish Fed in the coming years.


So if you believe that policy will turn out to be more hawkish than that, then you should be putting on trades that the spread will widen (for example, buy Dec 2018 at 97.91 and sell Dec 2019 at 97.73  = .18 bp). It's a relatively cheap way of betting on the US sustaining solid growth with all its attendant inflationary concerns. It looks particularly good value when contrasted with the price action in 5yr Treasuries, where yields hit a six-year high of 2.16% this week.


Just because it's cheap doesn't mean it's right of course, but somebody out there thinks it's worth a punt. Volume on the Dec 2018 / Dec 2019 spread has leapt this week, with 240,000 contracts traded on the first three days alone.


That's all very well, but what if you're a bit of a dove ..... if you believe that the Fed will not be able to live up to its stated intentions ? Well, then you take advantage of the apparent aberration between what going on in the Eurodollar market and the Treasury market. If you think things are going to progress more slowly than expected, then that yield on 5yr Treasuries might look pretty attractive. You'd be buying those in the expectation that yields will fall (and prices rise).


As ever, the market accommodates every view, and what's more gives you a range of vehicles to maximise returns. The only possible snag is that you've got to be right ......

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