FED vs EuroDollar: Who Blinks First?

On Friday (8/26), the world's central bankers, finance ministers, and other high level financial market participants will gather together and discuss world economics in Jackson Hole, WY.

This year, the global economy is eagerly awaiting FED Chairman Jerome Powell's speech addressing the country's interest rate policies for the next few quarters. It is expected that Powell will have a hawkish stance towards inflation. The expectation is that the FED will stand strong and continue to increase interest rates through 2023 to bring down inflation to their stated goal of 2%.

As noble as this stance may be, there is a group of market participants that believe the FED is wrong: The EuroDollar Futures Market.

The EuroDollar Futures Market is a highly sophisticated, insiders-only, trading market that conducts business on the Chicago Mercantile Exchange (CME).

Basically, it is a marketplace where large banks (JP Morgan Chase, Credit Suisse, HSBC, etc.) loan money to each other on a short-term or overnight basis. They do this to leverage their balance sheets, support derivative positions, or post collateral on loans. It provides the means for banks to secure an interest rate for money it plans to borrower or lend in the future. Everything in this market is denominated in $USD.

Most of the liquidity and trading happens on 2 year, 3 year, and 4 year contracts.

This market runs the world.

To put it in perspective - this market often surpasses the E-Mini S&P 500 futures (which is 50 times larger than the S&P 500) in terms of average daily trading volume and open interest. This market is worth hundreds of trillions of dollars a year.

The best way to think about this market is banks making long-term bets on short-term rates.

 Example: If I go and buy a two-year contract, I am making a bet on what overnight rates are going to be two years from now.

The yield curve has inverted steeply and the inflection point in this market is January 2023.

This means that the wealthiest, most sophisticated, and biggest players in the global financial system, who are betting their real money, think the FED is going to blink.

They believe, based on the trading happening in this market, that things are going to get so bad that the FED is going to be forced to cut rates and a severe recession will ensue.

Two things can happen here:

1. EuroDollar Futures market can be right  
2. The FED can be right

If the FED is right, that means that the FED stays vigilant in their fight against inflation. It means that interest rates continue to rise at a steady pace until inflation is subdued and the US will continue to see the high interest rates on mortgages.

If the EuroDollar Futures market is right, that means the US Economy will be at the start of a major recession. High rates of layoffs will occur, the stock market will drop, home prices will come down, and the US will be struggling. Therefore, the FED will have to step in and lower rates to spur economic growth.

To echo our blog post last week - do not "Date the Rate, Marry the House." If your buyers are getting this advice from someone, run the other way.

Both the US Economy and the buyer's personal financial life will not be the same as it is today if rates go down. They may be experiencing a layoff in the home, their home could have depreciated in value, or they could have just lost their savings account. All of these scenarios affect a person's ability to refinance.

Your client's financial situation today is not the same it will be in the future. It is merely a snapshot of where they stand today.

This is not a fear-mongering tactic. It is supposed to act as a 30,000 foot view of the US economy and how it can seriously impact your clients, because real estate is not a silo.

It is also not to say that now is a bad time to buy a house. If the client is comfortable with the monthly payment (not stretching) and are not wiping out their savings to buy the home (save 4-6 months of mortgage payments), they actually have a ton of leverage in the market right now. The next 6-12 months will most likely be the best time to buy a house we have seen since 2010.

We do not know who is going to be correct in the end. But, what we know for certain is that we will find out the answer soon.