Traders Are Testing The Fed Today -- Here's What To Look For In The FOMC Minutes

Following the release of stronger-than-expected private payrolls numbers this morning, traders are pulling forward expectations for when and how fast the Federal Reserve will normalize short-term interest rates from current ultra-low levels between 0 and 0.25%, where they have been pinned since the financial crisis.

As Chart 1 shows, yields on eurodollar futures contracts, which reflect where the yield on 3-month dollar deposits held in bank accounts outside the United States is expected to be when the contracts mature, are rising across the board today.

They are also up substantially from December 18, when the Federal Open Market Committee announced the beginning of the process of winding down (a.k.a. “tapering”) the Federal Reserve’s quantitative easing program, under which the central bank buys $US85 billion of U.S. Treasuries and mortgage-backed securities each month. Chart 2 shows how much yields on each eurodollar futures contract have risen since yesterday and since December 18.

“As the labour market improves at a faster-than-expected pace, expectations for the Fed’s first rate hike are typically priced in at an earlier date,” says Gabriel Mann, a U.S. rates strategy analyst at RBS. Or in other words, eurodollars have sold off as investors pulled forward the expected date for the Fed’s first tightening.”

Today’s price action in eurodollar futures highlights what is likely to be the biggest story of 2014 for interest rates: market participants testing the FOMC’s commitment (known as “forward guidance”) to keep the policy rate low well after the unemployment rate falls below 6.5% and the economic recovery becomes cemented.

“2014 will probably go down in history as the year of testing forward guidance,” says Aneta Markowska, an economist at Société Générale.

Today’s release of the minutes from the FOMC’s December 18 meeting will be thus be important for two reasons.

First, they could shed more light on the path the Fed’s wind-down of quantitative easing will take.

Currently, market economists surveyed by Bloomberg expect the FOMC to reduce the pace of its monthly bond buying by $US10 billion at each of its next seven meetings throughout 2014, ending the program completely by meeting number 8 in December.

“If today’s minutes unveil an FOMC that is united in ending [quantitative easing] sooner rather than later, yields will move higher still,” says Adrian Miller, director of fixed income strategy at GMP Securities.

The second big question the minutes could answer is what the FOMC is considering to enhance its forward guidance further, if it does in fact want to fight recent price action and keep expectations for future short-term interest rates at bay.

“Of all the options to strengthen forward guidance, the FOMC chose the softest one in December,” says Société Générale’s Markowska.

“It maintained the 6.5% no-rate-hike threshold, but added that rates are likely to stay at zero ‘well past’ this milestone. Judging from the Committee’s forecasts for unemployment and the fed funds rate, ‘well past’ probably means around 6-9 months (the FOMC’s median forecast sees the unemployment rate at 6.5% in late 2014 and the lift-off in rates some time in H2 2015). But what will happen if we cross the threshold sooner…does this mean that the lift-off in rates will also be brought forward to early 2015?”

The next FOMC meeting is January 28-29, at which the Committee must make a decision on whether or not to further bolster forward guidance.

“Importantly, there was no consensus within the Committee to enhance forward guidance in a forceful fashion,” says Jens Nordvig, global head of currency strategy at Nomura.

“In our opinion, this was no coincidence. The minutes today are likely to show that there is currently no momentum behind materially enhanced forward guidance at this juncture. For those who think Chairwoman Yellen is about to deliver a material dovish surprise, this could be viewed as hawkish news.”

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