The most important GIF of 2013 shows the recent shift in the eurodollar forward curve. Let’s talk about what this means.
In the past several weeks, traders have been pulling forward expectations for when the Federal Reserve will first hike short-term interest rates from current levels between 0 and 0.25% (where they’ve been since the financial crisis).
This can be seen by looking at eurodollar contracts, which reflect the future expected yield on 3-month dollar deposits outside the United States, and are a popular proxy for ascertaining the market’s expectation for when the Fed will hike rates. Where the forward curve crosses above 0.50% is essentially the point at which traders are pricing in the first rate hike from the current 0.25% level.
As the GIF shows, the curve has been shifting to the left recently, implying rate hikes sooner rather than later.
The green line shows the curve on November 20. That was before a much stronger-than-expected November jobs report (released on December 6), and a spate of other strong economic data releases.
The blue line shows the curve on December 18. It had already moved substantially from where it was on November 20 by then, but on December 18, the Fed announced the first tapering of its quantitative easing program.
And in the two days since December 18, the curve has shifted even further to the left — the red line shows where it stands today.
Why is this so important?
It captures the essence of the Fed’s biggest challenge in the year ahead: how does it keep short-term rates anchored in the face of improving economic data?
It also represents the big sea change in how people are thinking about the economy. Rather than assuming that zero interest rates will be here forever, they’re realising that the first hike could come much sooner as everything goes back to normal.
If the Fed can’t address concerns about a rate hike, markets could be in for a lot of volatility in the year ahead.
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