Tuesday, November 3, 2015

Eurodollars and Fed Funds Aren't Priced for Consensus Employment Report



The front end of the Treasury curve has traded soft since the October 28th FOMC meeting and its accompanying statement.  The market was unprepared for the indication therein that as much attention was being paid by FOMC members to the prospects for a policy rate firming at the upcoming December meeting.  The FOMC statement not only continued to recognize the pace of economic growth as ‘moderate’ rather than ‘modest’ as many thought they might, but they also removed from the September FOMC communication their stated concern for weaker global conditions.  These and other milder changes to the Statement helped to convince a greater minority of traders that the Fed might finally move forward with a policy transition. 

The yield on two year Treasuries rose by more than 8 basis points on October 28th, the most since March of this year.  There were only 4 other sessions within the last 3 years where two year yields advanced by a similar or greater magnitude.  Clearly, the message the Fed provided has prompted many Fed watchers to sharpen their pencils, dragging forward their assessment of when the Fed may begin removing accommodation. 

Further, the nearest to expiry quarterly Eurodollar future, EDZ5 (December 2015), fell 3.5 bps on the 28th, the most that contract fell in a single session (open to close) since August 4th.  Including the 28th session and since, the contract has maintained a low of 99.585 traded on each session (including today –Nov 3, thus far).   

As to the importance or implications of the decline on October 28th, we should note that Eurodollar futures volume on that session was 85 percent higher than the recent 15 day average.  Open interest rose by a 37,000 in EDZ5 that day and aggregate (all Eurodollar futures combined) open interest rose by a strong 141,000.  These volume and open interest developments combined with the large price move indicate that the decline was important and should have lasting bearish implications on trade. 

Many believe that in determining whether the Fed will move forward with indicated desires to begin policy normalization, a lot rides on the upcoming employment report scheduled for release this Friday.  If the non-farm payroll data bucks the recent decelerating trend or if there is some up-tic in the level of hourly compensation, we should expect that a grater, possibly much greater than 50% chance for a Fed hike of 25 basis points in December will be priced into the nearer to expiry Eurodollar and Fed Funds futures.

A recent Bloomberg survey suggests a consensus expectation exists for a non-farm payroll figure of 182,000 to prevail.  That compares with an average of 212,000, 194,000 and 185,000 over the last 12, 6 and 3 month averages respectively.  Clearly some of the ‘slack’ in the labor market has been taken up over the last years and a +200,000 number is no longer needed to further pressure the unemployment rate, already right on top of the Feds longer-run projection of 4.9% (median).  The above indicated survey further points to an expectation for a further drop in U3 unemployment from 5.1% to 5.0%.  Finally, average hourly earnings are expected to increase by 0.2% for the month, which is consistent with its recent and longer time-frame averages.  Year-over-year average hourly earnings are expected to increase to 2.3%, up slightly from 2.2% reported in September. 

If the above survey projections are met on Friday, my expectation is that nearer to expiry Eurodollar and Fed Funds futures will trade to lower levels than currently trading levels (FFZ5 99.805; FFF6 99.745; EDZ5 99.59; EDH6 99.44), pricing in a greater chance of accommodation removal in December.  There is still a good sized group of investors who believe that even stronger data over the near term will not sway the Fed toward removing accommodation and that the Fed will find some excuse to refrain from moving the policy rate. 

Using a ‘take-up’ (capture) of 20-22 bps from a policy firming of 25 basis points, moving from 0-25 to 25-50 basis point as a policy rate targeted range, I calculate that should the market price a 100% chance for a firming, EDZ5 would trade at 99.48-.49.  Remember however that even with a very strong payroll number this Friday, there still a lot of data to digest before the Fed meets in December.  Remember too, that the December Eurodollar futures contract expires just before the Fed meets, so it is less than likely even if the Fed makes every effort to guide expectations toward a policy firming, that EDZ5 will trade through 99.48…unless of course a greater expectations for a January 2016 policy rate move is priced. 

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