Some Rates Traders Nailed the Fed Call and Lost Money Anyway

(Bloomberg) -- Eurodollar futures and options traders just can’t win.

They’re already dealing with confusing policy messages from the Federal Reserve and the backdrop of an ongoing U.S.-China trade dispute. Now they also have to cope with a distortion -- caused in part by an expected surge in Treasury bill issuance -- that’s crushed otherwise profitable strategies.

The spread between forward rate agreements and overnight index swaps -- commonly known as FRA/OIS, the traded counterpart to Libor/OIS -- is a crucial component to the pricing of eurodollar futures and options that reference them. It has increased by more than 10 basis points in the three-month tenor since the beginning of June and shows little sign of easing.

FRA/OIS widening helps explain why some bullish eurodollar options positions have been cutting losses even as the market has priced in an increasingly dovish policy path for the Fed. Last week a super-dovish wager in December 2019 calls appeared to have been partially unwound at a loss despite a seemingly correct call on the Fed.

As the U.S. rates market rallied sharply on Monday -- a move that has resumed Wednesday -- pricing in an even more aggressive Fed easing path, December 2019 eurodollar futures peaked at 7.5 basis points over its previous 2019 high on June 20. The equivalent fed funds futures contract gained 14 basis points over the same period, a difference explained by FRA/OIS widening.

While FRA/OIS widening can signal credit-market stress, the current episode appears to be driven at least in part by the expected Treasury bill issuance surge tied to last week’s legislative accord to suspend the U.S. debt ceiling for two years. Libor and basis swaps have yet to fully price in the effects of the increased supply, Nordea Bank strategist Lars Mouland said in a note.

And with no end in sight to the surge in bill issuance, eurodollar traders may have to reckon with this distortion for a while.

To contact the reporter on this story: Edward Bolingbroke in New York at ebolingbrok1@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Elizabeth Stanton, Mark Tannenbaum

©2019 Bloomberg L.P.