Market Expectations for Policy Rates
The recent financial turmoil in Europe has been associated with a general shift in market expectations about the future course of domestic and foreign monetary policy. Implied yields derived from the fed funds futures prices shifted out the predicted path for the fed funds rate since early April—just before the dramatic increase in the sovereign credit default swaps spreads. Many market participants are now expecting the federal funds rate to remain near the 0–25 basis point range through the early part of 2011.
A Eurodollar forward rate is also often used as an alternative means for estimating the market’s expected path for the fed funds rate, especially for horizons of 6 months or more. The interest rates on 90-day Eurodollar futures to be delivered between September 2010 and December 2012 show a different pattern. Following the course of events that have occurred in Europe, one could reasonably expect the curve to flatten as it has with the fed funds futures rate. In this case, however, a flattening of the curve is also coupled with an upward shift.
Is this a signal that the Fed is expected to raise rates within the next few months? Not quite. Another key factor affects the Eurodollar forward curve as well. Because the Eurodollar involves borrowing over a longer term, it will carry more credit risk than the fed funds rate. The Eurodollar futures contract settlement price is determined by the 3-month London interbank offer rate (libor). As larger fiscal events have played out abroad and risks have risen, dollar Libor rate spreads have jumped markedly and have passed along their shorter-term increases into the implied Eurodollar rates.
The rise in LIBOR rates largely reflects a dollar liquidity problem in Europe, as banks are searching for dollar funding for their dollar-denominated assets. The fact that this is specific to dollar funding issues is corroborated by the pattern in the euro-denominated borrowing contracts (Euribor).
The implied expectations for interbank euro lending rates have also gone under a transformation throughout the sovereign debt crisis. Similar to a Eurodollar forward curve, a Euribor forward curve looks at the expected rate path for the associated interest rate. As opposed to dollar-denominated interest rates, such as the fed funds rate in the Eurodollar market, the Euribor market looks at the euro-denominated interest rate markets, producing implied expectations for the European Central Bank policy rate. Forward curves hint that expectations for the policy rate have been gradually falling as the European lending markets have struggled. In the span of three and a half months, expected rates for the end of 2012 have dropped ¾ percent.
Unlike the Eurodollar market, though, Euribor rates have remained steady in the short-term. This suggests that the liquidity problem that has developed is unique to the dollar, and perhaps represents a flight to safety in dollar-denominated assets. Looking at credit default swap spreads on the debt of some troubled nations (such swaps are generally understood as a form of insurance against a sovereign debt default), one can see a dramatic rise in the market stresses. Since the beginning of March, the spreads on Greek debt have risen nearly threefold, and spreads for Spain and Italy have doubled. Going forward, market anxieties will have to recede before forward rate curves can accurately portray policy expectations.