Tuesday, May 19, 2015
Shining A Candlelight on EDZ5
On the timeline, EDZ5 lies between tomorrows release of the April FOMC Minutes and Chicago Fed President Evans’ idea of when the Fed should start to normalize monetary policy with a firming of the fed funds policy rate. While Evans has remained vocal on his belief that the Fed should wait until 2016 before raising the fed funds rate, there remains a very modest minority who believe the Fed can and should begin this process as soon as the June 16-17 FOMC meeting.
Today’s housing data aside, much of the recent economic data has been less than what would be expected to prompt a Fed move anytime soon. This is why we find it curious that San Fran Fed President Williams, a former number two to Fed Chair Yellen during her tenure at the San Fran Fed, has been more friendly toward moving policy rates. New York Fed Dudley has also made more than clear that ‘each meeting is live’. Yellen herself had recently said that both equities and bonds were (too) high. She offered this at an ‘Institute for New Economic Thinking’ sponsored event on May 6th, arguably an odd place to drop such inferences.
Many have suggested that despite the softer economic data of late, the Fed is loathe to repeat the mistake of mid-2013 ‘Taper Tantrum’ where surprise announcement of forthcoming end of Fed asset purchases resulted in a sharp decline in Treasury prices. This they say is why some Fed officials appear more willing to proclaim ‘each meeting is live’, rather than any particular interest in moving sooner rather than later. To be clear however, the decline in Treasuries in mid-2013 had more to do with the lack of accompanying ‘policy path’ for tapering then the prospects of a scaling back of purchases. See FOMC Report December 17-18, 2013 and FOMC Report January 28-29, 2014 for some discussion on Fed ‘Policy-Path’ Guidance)
The last ‘Summary of Economic Projections’ (SEP) offered at the March FOMC meeting indicate a median year-end projected fed funds rate for 2015 of 0.63%. Using a simplifying assumption that the Fed moves initially in 25 basis point increments, a year-end fed funds at 63 bps would be consistent with two modest adjustments before year end. Fed funds effective rate was 13 basis points for May 18th.
December 2015 Eurodollar futures have been unwilling to price that much firming by year-end. EDZ5 trades at 99.42, slightly below the 99.44 settlement yesterday and the successive session high of 99.465 on May 14th, 15th and 18th. Three month labor marked at 27.6 bps today or roughly 14 bps above the ff effective of yesterday. Raising fed funds to 63 bps and leaving the spread between 3 month labor and ff effective unchanged would price EDZ5 closer to 99.23 with no rate hikes projected for the early part of 2016.
There has been some strong trading in EDZ5 99.375 puts lately with open interest rising to 280K as of yesterday. Many combinations were used to capture short positions through owning this put strike. Today there was good trading in the 99.375 99.25 99.125 put fly paying 2 (delta hedged to bring price down toward 1.75-1.85 tics).
Should the Fed more collectively indicate in the FOMC Minutes released tomorrow that they are nearly ready to move policy rates, market participants may be inclined to price more rather than less than year-end fed funds at 63 basis points and thus EDZ5 well below 99.42.
Technically speaking, EDZ5 has three consecutive highs at 99.465 and the doji from Friday indicates indecision while yesterday’s decline seems to indicate that the bearish contingency has found reason to become more confident. Today’s declining price action further supports the bearish implications of the bearish reverse from contract highs matched on Thursday, Friday and Monday. Current levels would appear to be a low risk entry point for hedging against higher rates in late-2015 if one uses the recent highs as a stop loss.