In December the Federal Reserve saw enough evidence of economic strength to begin tapering its Quantitative Easing (QE3) program and markets are adjusting to this new reality. So far it has been a tough pill to swallow with emerging markets being the first to feel the pains of withdrawal. And as we learned at the end of January, it is never long until emerging market fears impact domestic equity markets in some shape or form. We are now putting to the test a topic of much debate over the past few years: What are the effects of all of the excess liquidity produced by QE on external markets. Taking a closer look at Fed communications from the past year, it is clear that the Fed, too, is concerned about possible unintended consequences.
Go back to last spring when the Fed began talking about the inevitability of tapering its bond purchases. To say that markets were quick to respond is an understatement: 10-year note yields (CBOT:ZNH14) moved from 1.62% to 3%. Having learned from that experience, the Fed started focusing communication efforts on driving home the message that “tapering” is different from “tightening” and that markets should not get too far ahead of themselves as Fed policy would stay “accommodative” beyond the conclusion of the tapering process. While in September 2013, the Fed disappointed markets by not announcing the start of tapering (think back-to-back weak employment reports and a government shut-down) with yields dropping quickly, it followed through in December. Encouraged by strong economic data, including a GDP of 4.2% and a falling unemployment rate, the Fed began the unwinding process.
Another definite theme the Fed has been pushing is its data dependency. The Fed is going to great lengths to stress that economic data is what will dictate the pace of its tapering program. So far, in January, the economic data we have been receiving is mixed at best; while December’s nonfarm payrolls report was disappointing, GDP for Q4 was fairly strong at 3.2%. In spite of this, at its January meeting, the Fed decided to stay the course, announcing a further $10 billion reduction in its monthly bond buying program. The decision to taper took so long that it makes sense that their measured pace had to supersede one bad data point.
Undoubtedly, the Fed would like nothing more than a smooth exit strategy, given how overwhelming the great unknowns tied to the Fed’s initial intervention could turn out to be. And until we’re proven wrong, it may be a safe bet to believe that the Fed’s actions going forward, will in fact, be data-dependent. This should provide trading opportunities in the futures markets. As matters stand right now, the Fed is expected to keep cutting its bond purchasing program by $10 billion at each forthcoming meeting. This would bring QE to an end before the year is out, leaving some time before tightening is expected to begin sometime in mid-2015 according to the Fed’s own projections.
The Eurodollar curve, too, is suggesting that actual tightening will commence mid-2015. The high volume of futures contracts traded with expirations around that time is an indication of this. Using the Eurodollar June 2015 (EDM5) contract, there are a number of ways that you could trade the anticipated start of tightening. Early in January, EDM5 traded at 9920.5, suggesting the Fed would have tightened 50 basis points by June 2015, but the weak economic data so far this month had the contract moving higher, suggesting a move closer to 25 basis points. The red (2015) Eurodollar futures contracts are a good measure of economic conditions go forward. More complex plays, including spreads and the use of options on futures, are possible as well.
As mentioned before, the Fed continues to stress the fact that they will stay accommodative for a long time to come, suggesting that they are looking for the economy to accelerate first before they step in. In other words: they are more likely to want to play catch-up rather than anticipate positive developments. If this sounds right to you, a possible way to trade this sentiment would be to buy EDM5 and sell the EDM6, suggesting that the Fed will wait past June 2015 before they step in and tighten, but when they do, they will tighten at a relatively quick pace. Keep in mind also that using options on the aforementioned Eurodollar contracts would allow you to build a trading strategy that’s more closely tailored to your specific risk parameters and investment needs. That leaves the question: What’s your view on the economy?
Above: Chart of the June 2015 Eurodollar (EDM5) contract with Fed meetings marked. Since October, 2013, the contract has been trading in a defined range between 9920 and 9950. The contract hit a high before the December tapering decision and has rebounded in January as subsequent economic data has been more mixed. The contract has been trading higher suggesting reduced expectations of tightening to start in mid-2015.