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Eurodollar Curve Flattens as Fed’s Twist Extension Looms

Implied yields on Eurodollar futures expiring in 2015 are falling faster than those on contracts maturing in a year, suggesting traders consider more stimulus almost a sure thing when the Federal Reserve meets next week.

The difference, or spread, between the implied yields on the Eurodollar futures that expire at the end of 2013 and those that expire two years later is 42 basis points. The gap between the two rolling series contracts was as high this year as 125 basis points, or 1.25 percentage points, on March 20. Spreads have narrowed, known as a flattening of the implied yield curve, as traders’ price in record low benchmark borrowing costs for longer and as perceptions of credit risk in the European banking sector lessen.

Fed policy makers, who meet Dec. 11-12, may announce more monetary accommodation as Operation Twist, its program of swapping short- for long term debt, expires. The three-month London interbank offered rate, or Libor, which Eurodollar futures are settled in, has fallen after European Central Bank President Mario Draghi vowed to do whatever it took to save the 17-nation euro.

“Investors see front-end rates having a downward bias given the consensus view that the Fed will continue to add liquidity and due to a fall in the risk premium of unforeseen credit events coming out of Europe,” said Kenneth Silliman, head of U.S. short-term rates trading at Toronto-Dominion Bank’s TD Securities unit in New York. “The headwinds point to lower money market rates and a fall back in repurchase agreement and fed funds rates toward where they were before Operation Twist.”

Fed Minutes

The Fed lowered its benchmark interest rate to a range of zero to 0.25 percent in December 2008 and has said economic conditions will probably warrant holding it at record lows through mid-2015. The central bank is buying $40 billion in mortgage debt each month in its third round of quantitative easing aimed at keeping longer-term borrowing rates low to buoy economic growth.

A “number” of Fed officials said at their policy meeting in October that additional monthly purchases of bonds may be warranted next year, according to the minutes of the Federal Open Market Committee. Operation Twist will end this month.

Eurodollar futures, which signal where traders’ see Libor in the future and expectations on Fed monetary policy, are the world’s most-traded contracts. Movements in Libor, a gauge of unsecured bank borrowing costs, also reflect investors’ perceptions of credit risk in the banking sector.

European Sovereigns

The implied yield on the December 2013 contract was 0.36 percent today, while that on the December 2015 contract was 0.78 percent yesterday. The implied yield on the so-called rolling 13th-deferred future, now the 2015 contract, has fallen 27 basis points since Oct. 17, while the fifth-deferred, now the December 2013 contract, has falling 6 basis points during that time.

Draghi stabilized the European debt markets by showing greater willingness to use the ECB’s balance sheet to aid Spain and Italy. On Sept. 6, Draghi unveiled a bond-buying plan to tame borrowing costs of the region’s most-indebted nations and restore confidence. Spain is yet to request sovereign aid, a condition of the ECB purchases.

Three-month Libor has held at 0.3105 percent since Nov. 28, and is down from as high this year of 0.5825 percent on Jan. 3. The Eurodollar future’s implied yield is derived by subtracting the contract price from 100.

Unintended Consequences

Higher overnight interest rates on repurchase agreements and federal funds, included among money market rates, was one unintended side effect of Operation Twist, as dealers sought to finance record amounts of short-term debt on their balance sheets.

The overnight repo rate for Treasuries climbed to 0.266 percent on Dec. 5, from minus 0.001 percent on Dec. 3, a Depository Trust & Clearing Corp. general-collateral finance repo index shows. The average daily rate for overnight federal funds, the so-called fed effective has risen to 0.16 percent from 0.04 percent at the end of last year.

Futures traders are also pricing in lower rates amid a potential an influx of new cash into the money markets as government insurance on non-interest-bearing transactions accounts over $250,000 is set to expire on Dec. 30 and given heightened regulation.

The insurance coverage beyond the normal government limit was part of the Transaction Account Guarantee program, or TAG, which was implemented by the Federal Deposit Insurance Corp in 2008 and extended by the Dodd-Frank Act in 2010 as a way to shore up banks during the financial crisis.

“It’s almost consensus now in the markets that repo and other money market rates will go down next year,” said Viktoria Baklanova, an analyst in New York with Fitch Ratings’ fund and asset-management group, in a telephone interview.

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