Why The Fed Believes The Yield Curve is Too Flat

Eurodollar futures provide quite precise data about the market consensus forecast for interest rates. Since they extend out for ten years, they provide a rich set of information constantly updated about where market participants think 3 month Libor will be every three months.

The FOMC recently started making public the interest rate forecasts of its members. They issued a graphical representation of when FOMC members expect to begin tightening and what each member expects the year-end rate to be through 2014. You can find it here listed as “Projection Materials” for their press conference. For some weeks now I’ve felt that there exists a mild discrepancy between the rate forecasts imbedded in the eurodollar futures curve and the FOMC’s forecasts. For instance, only 6 of 17 FOMC members expect the Fed to begin tightening by 2013, whereas 11 (i.e. a majority) expect so by 2014. So the majority think they’ll be raising rates no later than 2014. Similarly, the median rate forecast of FOMC members at the end of 2013 is 0.25%, but a year later it’s 0.75%. Moreover, if you compare the average forecast rather than the median, rates are expected to move from 0.56% to 1.12% (there are a couple of outliers on the high side). So on balance, it looks as if the FOMC expects short term rates to rise around 0.5% during 2014.

Meanwhile, the spread between the September 2013 and September 2014 eurodollar futures yields is 0.36%. The market is priced for less of a tightening than the FOMC is forecasting.

Now eurodollar futures and the yield curve in general are analyzed probably more closely by more smart people than any other variable in financial markets. In addition, not all FOMC members vote, and it’s not clear what each members’ forecast is (although you can make some reasonable assumptions based on public comments by individual members). Current market pricing is not an oversight, it correctly reflects market expectations. And yet, were you able to sit in on a discussion of the FOMC, or better yet debate interest rate forecasts with them, they would likely tell you that the yield curve out to three years is not pricing in enough of a tightening of short term rates. Of course, the FOMC’s forecast could be wrong; after all, they really don’t know more than anyone else about what the economy will be doing in 2014. One interpretation of market pricing is precisely this – FOMC members are overly optimistic about GDP growth and the economy will still be facing headwinds 2-3 years out.

This may be so, and yet the knowledge that the FOMC thinks the yield curve is too flat would have been considered valuable inside information not so very long ago. Today, it’s public information. And they are of course in a position to make their forecasts come true.

The view that the yield curve is too flat can be most easily expressed through a long eurodollar futures calendar spread (long September 2013 and short September 2014), betting on a wider spread or steeper yield curve between those two points. Not everyone chooses to trade futures, but the rate forecasts revealed explicitly in the eurodollar futures curve are part of the term structure of bonds as well. Although the eurodollar futures market makes plain the precise path of interest rates the market expects, bond yields of different maturities are priced to be largely consistent with the same information. So an investor today who selects five year bonds over shorter maturity two years in exchange for the modest yield pick-up available is effectively rejecting the FOMC’s interest rate forecast as too optimistic on the economy. The FOMC is telling you they think you’re making a mistake.

Disclosure: Author is Long the September 2013/2014 eurodollar calendar spread.

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