Fed Takes a Back Seat for Traders Focused on Libor's Big Blowout

For traders focused on the short end of the U.S. rates market, next week’s Federal Reserve policy meeting is turning into a sideshow amid a relentless march higher in the London interbank offered rate and other money-market benchmarks.

With a quarter-point Fed hike largely priced in by the overnight index swaps market, all eyes are now on the surging dollar Libor rate and its spread over the OIS rate. A spread known as FRA/OIS, which measures market expectations for the Libor/OIS gap, this week breached 50 basis points for the first time since January 2012 and extended through 52 basis points Thursday.

The increase, partly a result of climbing T-bill issuance, is distorting the market for eurodollar futures, which are used to speculate about Fed policy and which settle based on Libor. Three-month dollar Libor jumped 3.25 basis points Thursday to 2.17750 percent, the highest since 2008, prompting a flurry of sales in March and June eurodollar contracts. Some analysts are wondering whether the events in the money market are going to draw the attention of policy makers.

“There’s a lot more bill supply that’s going to come, so we could see continued pressure on the front end just from the supply perspective,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale. “That should weigh on the Fed on the margin, given the whole money-market complex has repriced higher.”

See here for more about the sea change underway in money markets.

Questionable Signal

The price on the March eurodollar contract has tumbled 6 basis points this week ahead of its March 19 expiry, pointing to a Monday Libor fix of 2.205 percent, about 17 basis points higher than indicated at the start of the month. In a sign that the increase may not be due to shifting Fed bets, overnight swaps have been steady this month.

Traders in eurodollars have also seen some unusual options trades in recent weeks that could indicate hedging against a blowout in FRA/OIS. One particularly aggressive put-option structure that traders started talking about last month stands to pay off if the Fed hikes twice by August and FRA/OIS leaps an additional 20 basis points by then.

Read more on why Libor-OIS spreads are widening.

The movements in Libor have also distorted front-end eurodollar spreads, prompting curve trades as investors seek out areas they consider to be mispriced.

The latest futures positioning data, through March 6, drive home the extreme bearishness across the eurodollar market, although it’s hard to interpret how much is attributable to Fed expectations and how much to fears of a Libor blow-out. Net shorts for asset managers and speculators are close to records.

In the wake of strong payrolls data and signs of an inflation pickup, Goldman Sachs Group Inc. predicts the Fed’s median forecast for rates -- known as the dot plot -- will shift at next week’s meeting to indicate four quarter-point hikes this year. Other forecasters are still leaning toward the central bank sticking to its previous projection of three increases.

Either way, the Fed is far from the whole story for traders in eurodollars. It could well be that fluctuations in Libor next week draw as much interest as the central bank’s decision.

— With assistance by Brian Chappatta