In the corner of the US fixed income market that is most aligned with Federal Reserve policy, a bet has emerged that will pay off nicely if traders move up at the time when they expect the next tightening cycle to begin.
Trading is done via options on eurodollar futures and it has been in size over the last week. The start-up coincides with opinion polls suggest a growing chance for a democratic sweep of both the White House and Congress in the November 3 election. For many investors, this scenario will pave the way for a significant fiscal package, potentially accelerating the economy’s recovery from the pandemic and accelerating inflation towards the Fed’s target.
That betting in focus has cost around $ 1 million in option premiums with a maximum potential payout of approx. $ 50 million. It will prove to be most profitable if futures in the next quarter have priced corresponding to approx. three quarter-point rate hikes before March 2024, meaning the Fed tightens beginning months earlier. By comparison, the euro dollar market does not even reflect a full quarterly rise until June 2024. The Fed, for its part, signals that it will keep interest rates at least through 2023.
“Forward-looking Eurodollar contracts are affected by where interest rates are in the next or two years – can you say for sure that there will not be a big rise in inflation in the next two years?” said Alex Manzara, a derivatives broker at RJ O’Brien & Associates.
A buyer of this option bet began to show up on October 9, when most of the purchases took place. The position consists of more than 660,000 options, which has created eyebrows among traders, just like the sum at stake.
See here for more on the structure of the trade.
The betting has created buzz in a market where activity is declining, in part because the Chicago trade pit was closed for several months in the middle of the virus. Since the beginning of the year, the daily volume of Eurodollar options has exceeded one million contracts on 98 occasions, of which only 10 have come since the beginning of May.
$ 50 million disadvantage
The potential losses if the bet does not work before the expiration date of March 12, 2021, increase attention. The downside could be around $ 50 million if the market moves in the opposite direction towards pricing in a negative Fed rate.
That, of course, is a step that Fed officials have repeatedly said they do not want to take. And it is hardly the economic result that the markets support, with equities not far below record highs. And further stimulation can come regardless of the election result.
Click here for more about which markets are expected.
“It will rely on perception,” Manzara said. And the perception behind the purchase of such a Eurodollar option structure “is that no matter who wins the election and even if they have not been able to agree on stimulus, big stimulus is coming,” he said.
What to see
- The financial calendar
- October 19: NAHB housing market index
- October 20: building permits; housing starts
- October 21: MBA mortgage applications; Fed Beige book
- October 22: Weekly Unemployment Claims; Bloomberg economic expectations, consumer comfort; leading index; existing home sales; Kansas City Fed manufacturing activity
- October 23: Markit US production, services, composite PMI
- Fed Calendar:
- October 19: President Jerome Powell joins the IMF panel on cross-border payments; New York Fed’s John Williams; Vice President Richard Clarida; Minneapolis Fed’s Neel Kashkari; Atlanta Fed’s Raphael Bostic; Philadelphia Fed’s Patrick Harker
- October 20: Vice President of Random Quarterly Supervision; Chicago Fed’s Charles Evans; New York Fed’s Daleep Singh; Bostic
- October 21: Cleveland Fed’s Loretta Mester; Kashkari; Dallas Fed’s Robert Kaplan; Fed Beige book
- October 23: New York Feds Lorie Logan
- The auction calendar:
- October 19: 13-, 26-week bills
- October 20: 119-, 42-day bills with cash handling
- October 21: 20-year bonds reopen
- October 22: 4-, 8-week bills; 5-YEAR-OLD TIPS