Officials including Boston Fed President Eric Rosengren have said it’s time to consider... Read More
The Federal Open Market Committee begins a two-day meeting in Washington tomorrow as unemployment declines and the economy picks up. Officials including Boston Fed President Eric Rosengren have said it’s time to consider dropping a pledge to keep rates low for a “considerable time” after the completion of the central bank’s bond-purchase program, which is set to end after the October meeting.
“What people are looking for is some sort of signal from the
Fed that, yes, they are shifting out of stimulus and moving closer to the tightening stage,” said Boris Rjavinski, a New York-based U.S. interest-rate derivatives strategist at UBS AG, a primary dealer.
Speculation that such a signal may be at hand is apparent in trading using options that expire within the next few months.
Since the FOMC’s last meeting in late July, the number of open put options contracts that expire this year and grant the right to sell Eurodollar futures that expire in December 2017 has risen to the highest level of the year relative to that for call options, which allow for purchases of the money-market derivative.
Eurodollar futures contracts, which are priced at expiration on the three-month dollar London interbank offered rate, are used to speculate on the future path of the Fed’s benchmark rate.
Options Wager
Investors in put options are betting that market participants will raise their expectations for the level of the federal funds rate in 2017. They are wagering that Fed policy makers meeting this week will forecast a higher rate at the end of 2017 than most investors now predict.As of Sept. 10, there were 3.2 active put options for every active call option, according to data from CME Group Inc. That’s up from a ratio of 1.9 on the final day of the FOMC’s July 29-30 gathering.
Using short-term options on the contract allows traders to place a bet on a policy surprise from the Fed at a relatively low cost and limits the damage in case the trade doesn’t work out, because holders of the options can only lose as much as they paid for them.
Rosengren, Plosser
Speculation on a change in the Fed’s forward guidance has been reinforced by recent remarks by policy makers who want to keep rates low for longer, like the Boston Fed’s Rosengren, along with those who prefer to raise them sooner, such as Philadelphia Fed President Charles Plosser.Both have said since the Fed’s last meeting that they want to move away from promising to keep rates low for some unspecified period of time and toward tying the first increase to changes in inflation and the job market.
Policy makers this week will update their projections for U.S. unemployment, inflation, and their estimate of where the funds rate should be in 2014, 2015 and 2016. The new set of forecasts will for the first time include the outlook for 2017. In June, officials forecast that the fed funds rate, which has been held near zero since December 2008, would be raised some time next year.
Options traders are betting that Fed officials’ estimates of where the policy rate will be at the end of 2017, displayed as dots on a chart, will be significantly higher than the 2.73 percent rate currently signaled by the December 2017 contracts. Yields implied by Eurodollar futures move inversely to the price of the contracts, so when yields rise, prices go down.
Bearish Bets
“The trade du jour now is selling 2017 Eurodollar futures or using options on the contracts to set bearish bets,” said Stan Jonas, former managing partner of Axiom Management Partners in New York. Traders in options appear to be “convinced that the FOMC will present a December 2017 ‘dot’ around 3.25 percent or even higher, which is well above where the market now has it priced.”The jump in activity has been noticeable. Short-term options trade on the December 2017 Eurodollar futures contract, as a percentage of options trade on Eurodollar futures of all maturities, was 17 percent in the 10-trading-day period ended Sept. 10, up from the 11 percent average in the two months to Sept. 10, according to CME Group data. Average daily volume in all Eurodollar options this year is 795,000, 41 percent above last year’s average, according to Agha Mirza, New York-based executive director of interest rate products at CME Group.
Low Volatility
Yields implied by December 2017 Eurodollar futures have risen 0.21 percentage point over the last week. At least part of that move has been linked to a report last week by researchers at the San Francisco Fed, who wrote that low financial market volatility might signal investors were underestimating how quickly the Fed could raise rates.The majority of the options bets placed in recent weeks against the December 2017 Eurodollar futures contract “are for October expiration, which will take into account the September FOMC meeting, and also the November expiration contracts that will take you through the October meeting,” said Todd Colvin, senior vice president at RJ O’Brien & Associates LLC in Chicago. Almost 79 percent of the short-term options bets on that contract placed since Fed Chair Janet Yellen’s Aug. 22 Jackson Hole speech expire in the next two months, according to CME Group data. In her speech, Yellen said the U.S. labor market “has yet to fully recover” from the effects of the recession.
“People have learned the fact that there have been so many twists and turns in this whole business of trying to forecast what the Fed will say or what the Fed will do, so I think it’s only logical that options feel like a safer bet,” said Rjavinski at UBS.
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