The most interesting question heading into last Wednesday’s Federal Open Market Committee meeting — at which the FOMC ended up announcing the first reduction in the Federal Reserve’s quantitative easing program — was how the decision would affect short-term interest rates.
Back in the pre-crisis days, moving short-term interest rates up and down was the standard tool that the Fed used to stimulate or cool down the economy.
Short-term interest rate futures can be used as a proxy for the market’s expectations of where policy rates — e.g., the fed funds rate that the Fed manipulates to provide the economy with monetary stimulus — will be in the future.
Our favourite market to watch in order to gauge reactions to Fed policy is not the stock market, nor the Treasury market, nor gold.
It’s the eurodollar futures market, and in the last week we’ve been hammering away on the point that in every trading session since the FOMC decision, eurodollar futures have been selling off, forcing yields on those contracts higher. In other words, the eurodollar futures market keeps signaling that the date of the first Fed rate hike is getting closer and closer.
Eurodollar contracts reflect the future expected yield on 3-month dollar deposits outside the United States (and therefore outside the Fed’s purview as a regulatory body). These are useful to look at because they are much more liquid than fed funds futures.
The sell-off and attendant rise in yields in this market suggests that market participants are repricing expectations for when they expect the FOMC to first hike short-term interest rates from current levels between 0 and 0.25% — where they’ve been pinned since the financial crisis — as well as the speed at which the Committee will return short-term interest rates to more “normal” levels.
The chart below shows recent changes in the eurodollar forward curve.
The bright red line shows where the curve stands today. Yields are higher at almost any point along the curve today than they were a month ago (blue line), on December 18, when the FOMC announced tapering of QE (maroon line), or even yesterday (green line), before we got big upside surprises in November durable goods orders and new home sales data.
Keep an eye on this market. The curve will likely continue shifting to the left if the economy continues to improve faster than expected, implying faster rate hikes sooner and challenging the FOMC’s pledge to keep policy rates low for another two years. That could be a recipe for market volatility in 2014.
The big question, then, becomes: how far is the Fed going to let this run?