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An investor’s guide to blaming the Fed for market volatility

The Eurodollar futures market is unknown to most investors – the fact that a single contract costs $1-million keeps out most of the riffraff such as you and me – but it remains the place where the biggest, most informed, most motivated investors place their bets on interest rates. This includes the major banks that use Eurodollars as a hedge for interest-rate risk in their mammoth mortgage loan books.

Central-bank policy is always an important driver of interest-rate expectations but now the Federal Reserve is more important than ever before. The really new wrinkle, one that's most important for investors, is that chair Janet Yellen and the Fed are now the main determinants of S&P 500 performance in the current environment.

The chart below compares the fluctuations in the U.S. equity market to the Eurodollar-implied future of interest rates. Specifically, the orange line shows what the futures market expects short-term interest rates to do (specifically, the three-month London interbank offered rate, or Libor, which is priced from central-bank rates) between March, 2016, and March, 2017. For instance, the first data point indicates that on Sept. 30, 2015, Eurodollars were predicting a 0.55-per-cent (55-basis-point) rise in rates for that period. A rising line indicates expectations for higher interest rates.

Equities and inflation expectations were roughly aligned during the fourth quarter of 2015 and the relationship tightened considerably after the Fed hiked rates on Dec. 16.

The trends on the chart have numerous important implications for investors in all markets across the globe. For one, the close association between the two lines in 2016 strongly suggests that Fed policy and interest rates are creating the extreme levels of equity-market volatility in 2016.

The falling orange line also suggests that Eurodollar markets – and again, these are the biggest, most sophisticated institutions in the world – do not believe the Fed will raise interest rates much higher this year. At the end of December, futures implied a 0.64-per-cent rise in interest rates between March, 2016, and March, 2017. That estimate allowed for at least two 0.25-per-cent central bank interest-rate hikes for that period.

At this point, the implied increase in short term rates is 0.34 per cent, which means only one interest-rate increase is expected. This is in sharp contrast to the Federal Reserve itself, which in December predicted that rates would climb by at least 75 basis points.

The chart also contains implications for U.S. economic growth. The declining expectations for interest rates also suggest lower inflation is predicted. Economies that grow quickly create inflation pressure (in the United States, this would become noticeable in wage growth) and upward pressure on interest rates. The fact that rate expectations have fallen so far in 2016 means that Eurodollar market participants are also forecasting less economic growth.

The giant scale, relative obscurity and importance of Eurodollar markets have fascinated me for years but, in the past, the topic has seemed too technical to cover in detail. Now, however, with the market providing important guidance for equity markets and the U.S. economy, the time is right for investors to discover the Eurodollar futures market.

Eurodollar futures pricing can be found at the CME Group website. For investors looking to go more in depth, the CME also publishes the helpful guide, Understanding Eurodollar Futures.

Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.

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