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Forward ECB-Fed Money Market Rate Spread to Narrow, HSBC Says

Investors should use the forward markets to wager a derivative gauge of euro money market benchmark lending costs will decline relative to those in U.S. dollars, according to HSBC Holdings Plc.

The spread of future euro money market rates measured by overnight index swaps advanced above their U.S. dollar counterparts after the Federal Reserve said on Sept. 13 it is likely to hold its benchmark rate at a record low until mid-2015. One-year so-called euro OIS rates are above those in dollars priced two years in the future, while in the spot market they are less than their euro counterpart.

“The evolution of the euro OIS rates above the U.S. in the forward market is overdone,” said Subhrajit Banerjee, an interest-rate strategist in London at HSBC Holdings Plc. “Global markets have become more positive and have even begun to price-in some rate-hike expectations from the ECB in two years. We don’t see that as likely given the Fed’s guidance of no rate hikes until mid-2015. Investors should fade this OIS spread move.”

Central-bank actions this month, including European Central Bank President Mario Draghi endorsement of an unlimited bond-purchase program and the Fed’s new round of debt purchases, improved investor sentiment and lifted OIS rates with longer maturities more than with shorter ones. This so-called OIS curve steepening has lagged in the U.S. through 2015 given the Fed’s rate guidance, triggering the premium on euro forward rates.

Trade Recommendation

The euro OIS forward premium is likely to decline in the months ahead, according to HSBC, whose economists forecast the ECB will cut rates by at least the end of this year. They recommend investors receive fixed in one-year euro OIS traded two-years forward while simultaneously paying fixed on similar U.S. OIS contracts.

U.S. OIS swaps are based on expectations of the federal funds effective rate, while those in euros are based on the European Banking Federation’s euro overnight index average, or Eonia. The effective federal funds rate, a weighted average of all daily traders, was 0.15 percent on Sept. 21 while Eonia was 0.095 percent.

The one-year euro OIS traded two years forward was 0.501 percent today, while the U.S. dollar forward rate was 0.367 percent, for a spread of 0.13 percentage points.

The Fed has kept its overnight benchmark lending rate between banks locked at zero to 0.25 percent since December 2008. The ECB cut its main refinancing rate to a record low of 0.75 percent in July and left it unchanged at their most recent meeting on Aug. 2

Overnight index swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap.

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