Friday, December 5, 2014

Years Since Such ‘Normalization’ Seen in Eurodollar Pricing




It has been since January 2011 since the difference between the opening and closing prices in the 5th quarterly Eurodollar contract has matched or exceeded today’s 15 tics from open to last 99.20-99.05).  Additionally, we would note that the yield spread between EDZ5 (Red Dec - 5th rolling quarterly ED) and one year out EDZ6 (Green Dec) is roughly 100 bps.  



Last week I argued in ‘EDZ5; Giving Nod to Improving Financial Conditions’;’ Separately, the EDZ5 and the EDZ5-EDZ6 calendar spread point to likely still rising Eurodollar prices (lower interest rates).  Together, they make me want to ready for a better level to position for a return to pricing Fed lift-off toward June 2015 and for a more aggressively priced pace of accommodation removal.’

 

That expected rising price action for EDZ5 came early this week with a move from 99.22 to 99.31 and early on Tuesday I offered in ‘Last-Best Test of 'Cyclical Yield Low'; ‘Along with similar rejections throughout the curve and a steepening of the Eurodollar yield curve, I strongly suspect that yesterday’s advance may have been the last meaningful attempt against the mid-Oct yield lows (also the ‘cyclical yield low’) for the balance of the year (at least).’

 

Economists and traders alike are now moving forward their dates for the first policy rate move.  I continue to expect mid-2015 in either June or July.  Possibly more important; The fact that the rolling 5th Eurodollar is succumbing to such price pressure is further indication that ‘normalization’ is happening.  It has been a very long time since a significant portion of policy rate change expectation was priced so near up the curve.  This should be considered as a sign of stability as much as it is an indication for the more obvious implications for policy rate move pricing.  

 

 Scratching the Back of the Envelope:

There is not much changed in the ‘pace of policy rate adjustment’ priced today.  At the outside, 100 basis points show willingness to price roughly one quarter percent policy rate ‘target range’ increase every other FOMC meeting (8 per year).  There are 10 FOMC meeting that and policy rate responses that stand to have an impact on EDZ5 pricing (8 between EDZ5-EDZ6).  Right now, the EDZ5 contract prices roughly 71 basis points of policy firming over that period (EDZ5 99.05 less Spot 0.235), or roughly 7 bps per meeting.  This is not a bad estimate, but traders tend to overrun decent estimates and there would be those now looking for a surprise inflation report to prompt even earlier Fed policy rate moves than mid-2015.  

 

While the lift-off date may be priced even earlier than mid-2015  and before we are having picnics in the park again, the spread between EDZ5 and EDZ6 can more easily change from 100 bps to 120 without much psychological change at this point.  Step one has been made, it is likely that step two - an expectation that the pace of policy firming will be steeper than currently priced should be forthcoming.     



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