Photographer: John Taggart/Bloomberg

Bond Market's Hot Trade Is a Cheap Bet Fed Will Keep Its Promises

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With its latest rate increase, the Federal Reserve followed through on its plan to tighten three times in 2017. Now, bond traders are starting to load up on cheap bets that officials will deliver on their projections next year too.

In the eurodollar futures market, which is hyper-sensitive to Fed policy, demand is growing for wagers on a more aggressive pace of hikes than traders are currently pricing in. While the Fed expects to raise rates three times in 2018, most traders doubt they’ll manage even two hikes next year, given the prospect of tame inflation.

That skepticism can be seen in the flatness of the spread between eurodollar contracts that settle in December 2018 and December 2019. The gap remains close to its 2017 low, signaling traders see limited risk of a hawkish Fed in coming years. That’s a stark contrast with short-maturity Treasuries, with the five-year yield, for example, this week reaching the highest since 2011. The divergence between eurodollar rates and short-dated note yields gives traders two ways to express their Fed views. 

If they’re in the camp that the market is underpricing the resolve of policy makers to tighten, as measured by the Fed’s “dot plot” projections, traders should bet that the eurodollar spread will widen. But for those who see 2017 as an aberration, and expect officials to slow down, then perhaps elevated note yields look attractive.

The eurodollar spread trade saw record volume Monday, with almost 100,000 contracts transacted. Across Tuesday and Wednesday, almost 140,000 more came through, skewed toward bets that the spread would steepen.

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