Fed Funds Futures Adjust

The seemingly more hawkish stance taken by several Fed officials including Bernanke has helped spur the bout of dollar short covering. There is a sharp adjustment in interest rate expectations which is evident in the Fed funds futures strip. The market sees a little chance of a hike in Q1 but a higher target is fully discounted by the middle of Q2. The Dec 2010 funds contract is off 12.5 bp today to imply an effective Fed funds rate at the end of next year of 1.32% and given that the meeting is in the middle of Dec 2010, then it is implying an almost 1.5% Fed funds target by the end of next year. Although we have been in the camp that saw a risk of the first rate hike around the middle of next year, the market seems to be getting ahead of itself. At the same time, the US debt market is experiencing a sharp drop today with 2 and 10 year yields are 9-10 bp and 30-year yield up 7 bp. The long bond is experiencing its biggest drop since August after the lukewarm reception to yesterday's auction.

The dollar's firmer tone seems only partly related to backing up of US rates. Momentum traders seem to want to take profits ahead of the long US weekend and after the JPY88 level and the year's high in the euro held yesterday. In our understanding, interest rate differentials are a main weight on the dollar. Although interest rate differentials have moved in the US favor today, there had been a backing up in euribor rates earlier this week so the spread between eurodollars and euribor remains near the recent highs, which strikes us as still dollar negative.