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The Mechanics Of The Fed As Seen Ny The Eurodollar Curve

For a while, in that brief period between the August flash crash and the terrible September jobs report, it seemed that things may revert back to normal: bad news are bad news, good news are good news, and the economic cycle - as in the recession - is allowed to make a long-overdue repeat appearance from under the suffocating pressure of central banks.

Alas, it was not meant to be.

This is how DB's Alekandar Kocic explained it:

Last week’s developments in Europe (more QE, negative rates) and Asia (China cutting interest rates) are further reducing the probability of Fed liftoff. In all likelihood, we are one weak number away from a full relent and the market is already on the way to pricing it. But, to fully embrace this scenario, the market will likely wait for an explicit statement from the Fed. We continue to believe that repricing of the curve will follow a two step procedure with initial bull steepening followed by a bull flattening. This rates and macro view is roughly consistent with the curve approaching its shape of the late 2011, post low-for-long and operation twist, environment.

And while many - mostly those with no money on the table - debate daily what, how and when the Fed should move, for a specific subset of massively levered traders, even more so than the HFT algos who frontrun the equity market, every hiccup, stutter and vomit by Janet Yellen can mean the difference between early retirement and suicide (we hope this is a joke).

We are talking of course about Eurodollars, and it is Eurodollar traders who have been carted out feet first, year after year, having positioned (year after year), for a Fed rate hike that just doesn't come, and doesn't come, and doesn't come, etc in perpetuity.

In this case, the Eurodollar curve is also a useful barometer of what the market's consensus take is on what the Fed will do (at least until proven wrong by the Fed). And so, courtesy of DB, here is a quick primer on...

The mechanics of the Fed as seen by the Eurodollar curve

Eurodollar curve captures the mechanics of Fed expectations in a simple way. Away from the very front end, the curve dynamics is displays a rather rigid structure where a single risk premium parameter explains bulk of the spreads movement in different sectors of the curve. Typically, in anticipation of Fed hikes or cuts, the market makes up its mind about the terminal Fed funds (Greens) and begins to price in the rates path around that. The more aggressive the initial hikes are, the less they will have to do later. So, Red/Green spreads are highly coordinated with Green/Blue. The two spreads are roughly a mirror image of each other, Fig 1. This is in effect synonymous to summarizing dominant curve modes in terms of bull steepeners and bear flatteners.

As market anticipates rate cuts, the spreads begin to widen and continue throughout the easing cycle. They begin to tighten before the hikes. Towards the end of tightening the two spreads begin to pinch the x-axis. This is pre mechanics of the ED curve.

In that context, 2011-12 is a departure from the traditional pattern as low-for-long led to compression of risk premia in low rates environment. Taper tantrum is a snap out from that mode: Fed exit is announced and “normal” mechanics of the Eurodollar curve is set in place – the speads widen and they are beginning to tighten as expected rate hikes is approaching. This was in place roughly, with some additional wrinkles, until the last summer.

The dynamics in the H2 is consistent with the market anticipating another episode of squeezing of the toothpaste. Reds have already rallied. Greens should follow, while in the near term blues are likely to hesitate before we have more clarity about the Fed in 2016 and beyond. Figs 2 & 3 illustrate departures of the current dynamics from historical pattern post-2008 as seen by both spreads and individual forward rates.

Fig 3 illustrates the timeline of the last two years. It addresses the corresponding dislocation in spreads as seen on Fig 2. The compression of the spreads has been a result of two distinct dynamics. 2014 has been by and large a result of repricing the terminal rates lower. It was dominated by the Green/Blue flatteners, while Reds traded sideways for the most part – short term rate hikes remained on the table.H1:2015 was a finessed version of the same mode with Reds pushing higher as consensus was shaping around Sep- 2015 hikes, thus, a more aggressive Red/Green tightening.

This appears to be a true structural break of the mechanics of Fed expectations, as captured by the curve, Red/Green vs. Green/Blue interaction (two mirror images) has changed. This is highlighted in Fig 4 across the two samples: (2011-2013 blue and 2014-15 red).

The last leg of curve repricing corresponds to pricing Fed relent – taking the near (and possible intermediate) term hikes out. This is a Red/Green flattener with roughly a parallel shift in Green/ Blue sector. So the first installment of Fed repricing, red/green steepening has already been taking place. The next step is the red/green flattening or green/blue steepening. Given the vol pricing and carry consideration, we are buyers of conditional bull steepeners in terms of mid-curve receivers.