From the February 2013 issue of Futures Magazine • Subscribe!

Eurodollar yields and a twisted curve

Sharp upswings in the three-month and one-year rates generally show the Federal Reserve policy of controlling overly exuberant economies with reduced liquidity, leading to higher short-term rates. The five-year and 10-year rates form a relatively smooth downtrend following a peak in 1990, with short-term rates first escalating in response to Federal Reserve tight-money policies and then falling sharply as the economic bubble burst. The chart also shows the repeated cycle of the Fed fighting price inflation (another of its mandated objectives) by absorbing liquidity, followed by infusion of liquidity in an attempt to restore economic growth.

The most recent episode of Federal Reserve actions leading to an economic downturn is shown in “Yields and rates” (below). The peak in 2007 is typical in that short-term yields are higher than long-term yields in an inverted yield curve produced by a policy of selling short-term Treasury securities by the Federal Open Market Committee. The shortest-term yield is 5.4% while the five-year and 10-year yields are approximately 4.8%. Eurodollar quarterly rates always have to be adjusted so that the Eurodollar yield curve is close to the U.S. Treasury yield curve.

On Feb. 1, 2007, the market could not quite achieve this objective, but its valiant attempt made the Eurodollar quarterly rate curve dip under the Eurodollar yield curve. Thus, Federal Reserve policy caused Eurodollar futures to have an inversion of their own because Eurodollar quarterly rates usually are higher than the corresponding yields.

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