Bond Traders Double Down on 2017 Fed Bets Via Options HedgesBy and
Growing expectations for a September pause and a December hike
Eurodollar options market following theme of futures trading
Bond traders are ramping up wagers that the Federal Reserve is done raising interest rates until December.
Open-interest data from the eurodollar options market in the wake of the Fed’s rate hike last week show traders are piling into a bet already popular in futures: that the central bank will skip a September rate increase and wait until the final policy meeting of the year to tighten again. That’s reflected in the buying and selling of call spreads on futures contracts.
Here’s how it played out: A trader bought a call on the September eurodollar futures contract, known by its ticker EDU7, at 98.625, and sold two calls on the same contract at 98.75. That position gains if EDU7, currently trading at 98.65, stays between the two strike prices. It would do that if the bond market continues to see little chance of a hike in three months. The odds of a September hike are about 13 percent, based on the current effective fed funds rate and the forward overnight index swap rate.
The second leg of the trade involves a largely opposite wager on the December eurodollar futures contract, EDZ7. The same trader sold a call at 98.625 and bought a cheaper one at 98.75, pocketing the difference in premiums. The move will pay out the most if EDZ7 never makes it to 98.625, which it only touched once over the past month. It’s a bet on a December outcome that’s at least as hawkish as the market currently expects.
Bond traders are reassessing their views of the Fed after policy makers stuck to their interest-rate path in the face of disappointing economic data. After holding rates near zero for years after the financial crisis, officials have boosted their benchmark by a quarter-point every three months since December.
Their median forecast calls for one more hike by year-end, while also putting the central bank’s balance-sheet unwind “into effect relatively soon.”
With just two more decisions remaining with a press conference in 2017, traders are keeping in mind New York Fed President William Dudley’s remarks that a “pause” in rate hikes could be appropriate after the central bank implements its plan to trim the bank’s $4.5 trillion bond hoard. Eurodollars, even more than Treasuries, are a way to place bets and hedges closely tied to the path of central-bank policy. Positioning in the market for short-term rates started to shift toward December after disappointing U.S. jobs data June 2.
Wagers on a pause until December benefit from a wider spread between the September and December eurodollar futures contract. The current difference of 0.09 percentage point is up from 0.075 percentage point a week ago, though the spread was twice as wide at the end of 2016.
The options trades come from CME Group Inc. data and traders in Chicago and New York, who requested anonymity because they’re not authorized to speak publicly. The eurodollar futures market has a notional value of about $14 trillion.