Eurodollar futures trading at the CME Group are under severe pressure once again Wednesday. With the December contract closing beneath an established six-month long trendline yesterday, the acceleration in the move today is a textbook follow-through move. The catalysts are many, but the over riding theme is a re pricing of the likelihood of recession. With official rates now three percent below the cyclical peak almost two years ago, the market is beginning to sense that the Federal Reserve Bank may have done enough. The Bear Stearns failure was met with customary optimism that the Fed would have to ease further. However, that point in time marked the high-point in expectations for more rate cuts. On St. Patrick’s Day, Eurodollar futures traders had predicted that rates would slide to 1.75% by the end of this year.
The fact that the Fed then stood behind JP Morgan’s move and became the effective “backstop” has effectively drawn a floor beneath the health of other institutions. The accompanying rise in stock markets has taken the immediate and severe pressure off mortgage lender, Thornburg and possibly many others facing the daily rigmarole of margin calls. The more air all of these institutions can inhale, the easier it is to breath across all markets. In the case of the interest rate market, the bubble had grown larger because the housing market’s problems were destined to play out regardless of Fed action. It wasn’t the level of rates that mattered. New life can’t be born to that sector of the economy until the natural course of events has run. Today the best prediction of where the Fed will stand at year end has been revised to 2.5% as longs are ejected from the market while those asking “what recession?” have their day in the sun.
The decline in interest rate expectations follows a much more positive survey this week, which fed the equity market’s enthusiasm for risk. In the last two sessions the December Eurodollar future has shed a whopping 33 basis points (a third of one percent). Some analysts recently questioned the dollar’s strength thinking that the widening of spreads vis-à-vis the euro currency would perhaps extend dollar weakness. Well today we’re also seeing a widening of spreads in the Eurodollar market, which could further fan the flames of recovery for the dollar. For example the gradient of the curve between the June 2008 and June 2009 futures is just 25 basis points indicating that rates will rise to 2.75% by summer next year. Recently, that spread stood at 46 basis points. The December 2008/2009 spread predicts a 75 basis point rate rise over the intervening period, but this spread was almost 1% wide just several weeks ago. The wider these spreads get, the more reversal they predict from the Federal Reserve going forward. The bottom line is that as economic data releases question how far the housing slump has spread to other areas of the economy, the more interest rate traders will fear that Fed will take away what it’s spent nine months delivering. When the forex market unravels this message, the dollar’s nascent recovery could blossom.
Andrew Wilkinson
Interactive Brokers Group LLC
