Trade Idea: Long September 2011 Euro-Dollar contract

The sell-off in the September 2011 Euro-dollar contracts after the latest FOMC meeting seems to wrongly price the beginning of the Fed’s tightening cycle. Prior to the QE2 announcement, the tightening was priced in close to the end of Q3 of 2011. This has changed dramatically with the tightening now being priced in close to the end of Q1 2011, as suggested by the March 2011 contract.

The announcement of $600bn in QE2 itself is a stance of easing which should have, if anything, pushed out the tightening cycle of the Fed. There are arguments suggesting that the sell-off was plausible since the Fed has a reasonably strong GDP forecast of 3.3% for 2011, which will probably be enhanced by the QE announcement. On the contrary, I believe the Fed’s tightening will more likely be determined by the unemployment rate. Interestingly, the Fed has revised up its unemployment forecast for Q4 2011 to 9% from 8.5% previously.

Many market participants worried whether the Fed will complete its stated $600bn in Treasury purchases, citing future inflation as a problem. The Fed minutes seem to have clarified its strong commitment to this policy. There are in fact reasons to believe that the Fed has potential to do more if required. The minutes from the Fed meeting included an FOMC videoconference on October 15, 2010 at which the members discussed a several possible easing steps, with the announced program described as an “incremental approach” as opposed to the much talked about shock and awe approach. This terminology only suggests that the stated amount of $600bn is very likely seen as a first installment. Given the Fed’s determination towards easing, the economy would need to improve beyond its forecasted 3.3% level, accompanied by a gradually declining unemployment rate. Such developments seem highly unlikely in the next three to six months.

Of course, it has to be acknowledged that the QE2 program got off to a rough start due to global political developments, market volatility and the Fed’s internal dissent. To address the latter, the “meeting opened with a short discussion regarding communicating with the public”, and the members supported a review of the FOMC’s communication guidelines with the aim of ensuring that the public is well informed about issues in monetary policy, while preserving the necessary confidentiality of policy decisions, until their scheduled releases.

Given this context, I recommend going long the Eurodollar contract for September 2011 expiry.

September 2011 contract

Implied short term rate: 0.705%

March 2011 Contract

Implied short term rate: 0.525%

Current Fed funds target rate: 0% to 0.25%