Buy Eurodollar Puts in Anticipation of Higher Rates
Federal Reserve Chairman Ben Bernanke’s speech Tuesday indicated to market participants that the Fed was finished lowering interest rates this year, and would be turning its focus to inflation. That being the case, buying Eurodollar puts is a strategy to consider, given the higher rates seem likely ahead.
Eurodollars are deposits denominated in U.S. dollars at banks outside the country. CME Eurodollar futures prices reflect market expectations for interest rates on three-month Eurodollar deposits for specific dates in the future. The final settlement price is determined by the three-month LIBOR rate on the last trading day. The futures prices are fairly straightforward, derived by subtracting that implied interest rate (yield) from 100. For example, an anticipated interest rate of four percent will translate to a futures price of approximately 96.00. Keep in mind, price and yield move inversely to each other. Different economic reports will cause rate expectations to adjust, and Eurodollar futures will move accordingly.
The market is pricing in a rate increase as the next move from the Fed, at the earliest September, but perhaps not until next year. Bernanke said the “possibility that commodity prices will continue to rise is an important risk to the inflation forecast,” adding that “high headline inflation, if sustained, might lead the public to expect higher long-term inflation rates, an expectation that could ultimately become self-confirming.” He added the Fed expects “somewhat better economic conditions during the second half of 2008” and further recovery in 2009.
The interest rate futures markets in general have been supported by a bit of a flight to quality bid, on concerns about the health of the financial sector. Lehman Bros. is the latest company making headlines, and their upcoming earnings are expected to be dire.
September Eurodollar futures are trading at the upper end of a downward channel, trading near their weekly highs. I think the market should start to roll down. The September contract is implying a 3.48 percent interest rate that far out, and I recommend buying the September 2009 96.50 puts, which are currently at-the-money. At 55 points, or $25 a point, your cost would be approximately $1,375, plus your commission charges. That’s your defined risk on this trade. I can certainly see a 4.50 percent short-term interest rate by September. Once the Fed gets into the swing of raising rates, it could be aggressive as long as the fallout from the financial crisis ebbs, and the economy rebounds.
Feel free to call me to discuss these ideas further, or for ideas in other markets. Ask about our special half-off offer for new clients.
Phillip Streible is a Senior Market Strategist with Lind Plus. He can be reached at 800-803-8037 or via email at pstreible@lind-waldock.com.
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