Fed Rate-Hike Wagers Put on Back Burner as Blackout Begins

Stephen Spratt

April 19, 2021

Federal Reserve rate-hike expectations have been aggressively reduced over the past two weeks in the eurodollar futures market, just as policy makers enter their usual silent period before their April 28 decision.

The rapid repricing has removed around 15 basis points of rate increases from the December 2022 eurodollar futures contract. This shift away from fully pricing in a 25-basis-point rise has prompted Citigroup Inc.’s Jason Williams to fade the move and target fresh bets on a steeper curve.

It is a “puzzling move” that conflicts with the legitimate chance for a quicker-than-expected cycle of rising rates, the strategist wrote in a note Friday.

“The tail risks exist because there is a good chance that core PCE will trend well above 2% over the next one to two years, which may necessitate a more rapid hiking cycle,” Williams wrote. “We don’t think the bull flattening trend is sustainable in the front-end of the curve in the short-run.”

The emergence of a new bullish posture across the front-end has also recently been seen in the eurodollar options market. Friday saw a sizable upside mid-curve play targeting additional Fed easing priced into September 2022 eurodollar futures, which open-interest data confirmed as a new position.

A surprise rally in Treasuries in the face of robust economic data helped flatten the U.S. yield curve last week. Five- and seven-year maturities saw strong demand, suggesting aggressive bets on Fed rate hikes seen earlier in the year were being pared back.

Still, economic data in the next two months are unlikely to dent expectations for longer-dated inflation, according to Williams. There’s also a risk of more hawkish communication from the Fed this summer, especially about the so-called tapering of monetary support, he said.

Based on the history of how the curve has tended to behave around Fed programs, a bull steepening phase may come next, which would mean lower rates but a steeper curve, Williams wrote.

The strategist suggested clients could use the options market to place a trade known as a conditional bull steepener to profit from the return of some rate-hike speculation.

That would consist of buying bullish call options on June 2023 99.625 Eurodollar futures and selling 2024 99.00 equivalents, he wrote in the note.