Heading into this week’s Federal Open Markets Committee (FOMC) meeting that’s scheduled for April 29-30, economic data has been showing a pick-up in activity and corporate earnings have been coming in better than expected; with the spring thaw looking to release pent-up demand as expected. While these are good developments, this likely will keep the Fed on its current course of tapering, prompting a further $10 billion reduction in bond purchases at each forthcoming meeting.
It seems that markets have priced in the fact that the Fed will likely stay the course. Equities look to have recovered from its Nasdaq lead correction and the S&P 500 is back within striking distance of its all-time highs. There are signs also of companies that, up until now, have been hording cash actually putting money to work through mergers and acquisitions. Case in point: GE is planning on purchasing Valeant Pharmaceuticals and although GE is using money that’s been kept overseas, the fact remains that they are stepping up and putting funds to work. Facebook took a chance too, shelling out $19 billion for Whatsapp. While talk is that they overpaid, the fact remains they are making a move. On the fixed income side, things have been a little bit more surprising: with the long end of the curve, bonds, extending to new highs on a reach for duration while the five-year sector has struggled to follow suit.
The Eurodollar curve has spreads steepening with the pivot point of the curve moving out from June 2005 (EDM5) to September 2005 (EDU5). The market initially moved this pivot in when Janet Yellen commented that the Fed might start raising rates six months after the tapering ended but moved it back out when the Fed minutes suggested that it could be much longer. Outside of the United States, China has clearly put a stimulus program in place by weakening its currency some 13% since early January, and now back at levels not seen since February 2013. From the ECB, there also has been a lot of talk of more decisive action should inflation continue to fall. My guess is this signals that they are very close to actually taking action.
There remains little doubt that the Fed would like to wind down its bond purchasing program as soon as feasible, ending in October at current pace, with economic data ultimately dictating what will happen, and at what speed. Looking at the data at current levels, things do seem to be improving with the warmer weather across much of the United States. Should these changes actually manifest themselves in the employment and inflation data we could see the pace of tapering increase, moving the actual date of tightening forward. Having said that, ongoing geopolitical tensions between Russia and the Ukraine could constitute a substantial roadblock, keeping the Fed involved for longer.
As far as current tightening expectations go, looking at the Eurodollar curve for guidance, the market is anticipating the beginning of the tightening process to begin in June 2015 (EDM5), pricing in tightening by 25 basis points. Connected to this tidal change are a number of trading opportunities. Realistically, trades will turn on whether you think economic data will strengthen from here on out, forcing the Fed to increase the pace of both the taper and tightening, or whether you think the opposite is the case. Some of the ways of trading these major changes in monetary policy include playing the EDM5 or EDU6 contract long or short out right, or using options or calendar spreads (see chart).
The EDU5/EDU6 spread made a run at its highs of December and September of 2013, both constituting periods when the market was pricing in that the Fed would indeed begin tapering. With the spread back at its highs, confirmation that the economy is on firm footing would give the market the power to break through to the upside, underscoring the idea that the pace of the tighten process will likely quicken going forward. Conversely, a slowing of the economy would reduce expectations of the tightening process commencing sooner rather than later, with the spread likely heading lower. As things stand right now, the spread is at a crossroads, as is the economy, making me wonder where you think we’re headed?