Bond Traders Place a Cheap Bet That Fed's Still in Play in 2017

  • Eurodollar options show wagers on rising odds of rate increase
  • Market ‘unjustifiably’ dovish in its outlook, Citigroup says

Citigroup's Buiter Says There's Froth in Markets

Bets on another Federal Reserve rate hike this year are gaining favor after being all but abandoned a few days ago.

Eurodollar futures, among the most sensitive financial instruments to Fed speculation, show some traders have concluded that wagers on additional tightening in 2017 are too cheap to pass up. Last week, the market-implied odds of another rate increase by year-end plunged below 25 percent, and at one point fed funds futures didn’t fully price in another hike until 2019. Now, traders see the probability of one more hike in 2017 at about 35 percent.

That turn in sentiment was triggered by renewed evidence that the global reflation trade may be alive and well, with China and the U.K. reporting unexpectedly strong inflation data. The latest U.S. consumer-price figures come Thursday, likely setting the tone for Fed expectations heading into next week’s policy meeting.

“If you don’t get a downward drift in the dots or if you get an insufficiently dovish characterization around the inflation trajectory, that may help to push up rates and push up probabilities,” said Jeffrey Rosenberg, chief fixed-income strategist at BlackRock Inc., the world’s largest money manager. 

The Fed could hike again in 2017, he said, and should the momentum from the past two days continue, policy makers “have the wind behind their sails.”

Fed officials are expected to keep rates steady on Sept. 20, while announcing the timing of when they’ll begin tapering their $4.5 trillion balance sheet. That turns the market’s focus to December, the final decision of the year that includes a press conference, as the last chance for policy makers to follow through on their projection for three rate increases in 2017. 

They’ll update their outlook, known as the “dot plot,” next week. The median projection for year-end of 1.375 percent is unlikely to change, since five of the eight forecasts at the consensus level would have to drop, according to BMO Capital Markets.

High Stakes

That raises the stakes for traders doubting the Fed’s conviction to hike, especially after officials demonstrated ahead of their March meeting that they can ratchet up market expectations in a matter of days.

The level of eurodollar futures prices “implies unjustifiably dovish Fed expectations,” Citigroup Inc. strategists Ruslan Bikbov and Jason Williams wrote this week in a report. They recommended “options trades to fade the recent rally in the front end.”

Options traders are getting in on those bets.

One example seen in the market this week: A five-part eurodollar options trade which at its core is a wager that the price of the December eurodollar futures contract will extend declines as the market factors in a greater chance of a hike at year-end.

It’s a gamble that policy makers will stick to the plan they’ve been signaling all year. And with their track record of raising rates in March and June, and the promised balance-sheet reduction seemingly coming soon, at least some traders are starting to take the Fed at its word.

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