Monday, December 8, 2014
Step Two Begun; Eurodollar Futures Curve Pricing 'Normalization'
The steepening of the Eurodollar yield curve I spoke of on Friday (‘Years Since Such ‘Normalization’ Seen in Eurodollar Pricing’) as ‘step two’ following the strongest yield jump since 2011 in the rolling 5th Quarterly Eurodollar has begun. Much attention has been rightly given to the flattening of the Treasury curve on Friday. There was also some extraordinary flattening (11 basis points) in the Eurodollar yield curve from Reds (2nd year) to Golds (5th year).
We should rely more on the flattening of the Treasury 5’s-30’s, 2’s-10’s or 2’s-30’s than Eurodollar Reds-Golds. More easily diagnosed at this point however is the prospects for Reds to Greens (3rd year). The roughly 100 basis points that separates EDZ5-EDZ6 and even less priced in the 1 year calendar spreads starting EDH6 (93), EDM6 (82) and EDU6 (70) seems woefully shy of the extent of policy firming that can be expected to be conducted between those periods. Those expecting these spreads to remain as tight will have to expect either the Fed moves to a neutral policy rate very quickly and stops or is forced to retreat from too aggressive a firming process.
Both of these two conditions, while possible are not my base case. Instead, we should expect the Fed to begin at a slight pace of 25 basis point policy rate firming, possibly every other meeting, followed by a quicker pace over the next year. This would be consistent with a somewhat steadier pace of 3% domestic growth over the coming years.
For guide, the December 2015 contract may be a little difficult to pin as the Fed will still be moving up the learning curve on advancing the policy rate using its new tools of IOER, ON RRP and Term Deposits. Therefore, unless you have a specific view on that exact point on the curve, selecting March, June or September based calendar spreads may give a more consistent policy expectation view.