Market Minutes Overview:
- With acknowledgment from Fed Chair Jerome Powell that it’s time to “retire” the phrase “thinking about talking about [tapering],” it appears that the market is recalibrating itself to the start of the taper – and higher interest rates down the line
- Based on the Eurodollar contract spreads, there over 100-bps worth of rate hikes – collectively, four 25-bps rate hikes – by December 2023.
- Tomorrow is a quad witching day. Such occurrences typically breed higher trading volumes, and in the current context of a low volatility environment otherwise, tomorrow’s quad witching day might breed a relatively uncomfortable among of price swings in markets.
Dollar Screams Higher
As the coronavirus pandemic continues to recede in the United States, the Federal Reserve is becoming increasingly optimistic about the future of the US economy. The June Federal Reserve policy meeting didn’t shine details on a taper timeline, but with acknowledgment from Fed Chair Jerome Powell that it’s time to “retire” the phrase “thinking about talking about [tapering],” it appears that the market is recalibrating itself to the start of the taper – and higher interest rates down the line.
We can measure whether a rate hike is being priced-in using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future. Chart 1 below showcases the difference in borrowing costs – the spread – for the July 2021 and December 2023 contracts, in order to gauge where interest rates are headed in the interim period between July 2021 and December 2023.
Eurodollar Futures Contract Spread (July 2021-December 2023): Daily Rate Chart (January to June 17, 2021) (Chart 1)
Based on the Eurodollar contract spreads, there over 100-bps worth of rate hikes – collectively, four 25-bps rate hikes – by December 2023. This is a significant divergence from Fed funds futures, which are pricing in just two hikes, and a departure from the Fed itself which suggested that two hikes would be coming in 2023.
Historically speaking, sharp upticks in rate hike expectations vis-à-vis Eurodollar spreads have catered to a strong US Dollar environment. Indeed, technical advances by the DXY Index suggest a stronger greenback may be here in the near-term.
Video Technical Notes: DXY Index
- In a prior update, it was noted that “in recent weeks, below this multi-month flag support, a shorter-term bear flag has been carved out. But there has been no significant follow through, leaving open the potential for a bullish reversal within the range. Clearly defined ranges offer an opportunity for range trading, although with the Fed meeting this Wednesday, it may be the case that breakout conditions may be hiding around the corner.”
- The DXY Index has indeed experienced a bullish breakout, cracking above both short-term bear flag resistance and the multi-month bear flag support that defined price action beginning in late-November 2020. With bullish momentum continuing to build among technical studies, a more a significant US Dollar reversal higher may still develop.
Watch the Belly
The US Dollar is the best performing currency for the second day in a row as market participants digest the results of the June Federal Reserve policy meeting. This shift in sentiment has been confirmed by price action in the US Treasury yield curve, where the “belly” – 3- to 7-year notes – has seen yields rise faster than either the short- or long-end.
This is important to consider because…we’ve seen this before. This is akin to the situation that developed between May 22, 2013 (when Fed Chairman Ben Bernanke noted at a Congressional testimony that the Fed could taper QE3 in the next few meetings) and September 17, 2013 (the day before the September FOMC meeting). The chart below illustrates this point:
US Treasury Yield Curve Around 2013 Tantrum (1-year to 30-years) (May 22, 2013 to October 18, 2013) (Chart 2)
The US Treasury 7-year yield gained the most from May to September 2013, and when the September 2013 FOMC meeting came and went without a taper announcement, over the following month, the 7-year yield dropped by the most. Accordingly, if that steepening of the yield curve (a negative butterfly) in 2013 helped propel US Dollar strength, then it’s not a far cry to think that another steepening of the belly of the yield will help the greenback.
Moving forward, the belly of the yield curve should be eyed for hints on market expectations for Fed policy rather than the 2s10s spread or even the US Treasury 10-year yield itself.
Quiet Calendar to End the Week
A quiet end to an otherwise quiet week outside of the Federal Reserve meeting. True, a Bank of Japan rate decision is due before the week is out, but with measures of volatility remaining low and – seriously – the UEFA Euro games underway, there’s a good reason to believe that markets will stay quiet.
Alas, tomorrow is a quad witching day. A quad witching day is when single stock options, stock index options, single stock futures, and stock index futures all expire concurrently. Quad witching days happen four times a year, the third Friday of every March, June, September, and December. Such occurrences typically breed higher trading volumes, and in the current context of a low volatility environment otherwise, tomorrow’s quad witching day might breed a relatively uncomfortable among of price swings in markets.
DailyFX Economic Calendar, ‘High’ Rate Events, Next 48-hours (Table 1)
--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
