The Most Liquid and Least Talked About Futures Market in the World

Most people think of the euro currency paired against the U.S. dollar (EUR/USD) when I mention Eurodollar futures. However, Eurodollar futures have little to do with currencies and everything to do with interest rates. The simple definition of a Eurodollar is the interest rate paid for U.S. dollar deposits in non-U.S. banks. In essence, Eurodollars are the global benchmark for short-term U.S. interest-rate moves. These futures contracts, and the associated options, trade on the CME Group's division of the exchange. They offer unparalleled liquidity and are referred to by some as the fundamental building block of the financial market because of the ease offered to speculators and hedgers to express views on interest rates. Unlike most futures and options markets in which liquidity is in the front one to three expiration months, both Eurodollar futures and the options listed against them are reasonably liquid more than five years in advance. In addition to the liquidity, these products offer traders the ability to speculate, or hedge interest-rate risk, in a relatively conservative and comfortable manner. This is because Eurodollar futures come with low margins and cheap options due to the general lack of volatility and risk. That isn't to say things can't get heated; 2022 has been one of the most volatile years for interest rates in history and Eurodollar futures and options haven't been spared. Eurodollar futures represent $250,000 worth of dollar bank deposits earning the three-month London interbank offered rate. They are quoted similar to a discount bond; thus if the Eurodollar futures contract is trading at 98.50 it represents an interest rate of 2.5% (100 - 98.50). If the Eurodollar is at 99.00, it infers a rate of 1%. In light of a hawkish Federal Reserve and the infamous dot-plot game plan, we've seen Eurodollars fall from 99.00 to 96.85 in the front month (a rate of 1% to 3.15%)! That is an incredible move, a pace I don't recall ever witnessing. The stunning change in interest rates has been done on expectations of the Fed's future actions and expectations of inflation but, for now, these are speculations, not guarantees. We've seen the Fed lay out a plan and fail to follow through before. Only time will tell how this plays out. I tend to be in the camp that doubts the economy will be strong enough to handle what the market has priced in. Further, I suspect some of the inflation pressures coming from commodities could be lightening up (the supply-chain issues are a different story). If this premise is true, the Eurodollar should retrace some of its losses as it reverts to a less hawkish interest-rate outlook. Chart Source: QST Actionable Idea We've seen one of the quickest and largest interest-rate re-pricings in history. However, the Fed has merely raised rates once, which was more of a symbolic gesture than a game-changer. In other words, all of the interest rate turmoil experienced in bond portfolios, interest-rate futures, and the mortgage market has been on the mere expectations of Fed tightening. More specifically, the interest-rate risk has been created by inflation outlooks. As noted, neither of these things is guaranteed to become reality. What happens if the Fed nor inflation live up to the current expectations? Recent history suggests they might not. I can't recall the last time the Fed has carried out its full dot-plot plan. Those looking for a limited risk play on a long-term phenomenon could consider going long cheap March 2023 call options in the Eurodollar interest-rate futures. For instance, it is possible to purchase the March of 2023 Eurodollar 98.00 calls (inferring a short-term interest rate of 2% early next year for about $300!) This gives traders 325 days in the market with a risk equivalent to a few tanks of gas. Even more compelling, the market was pricing in a 2% rate (trading at 98.00) in the March 2023 futures contract in early March 2022, so if we merely revert back to the level of hawkishness last month, this option could pay off nicely. If not, the risk is low and limited.

The Most Liquid and Least Talked About Futures Market in the World

These products offer traders the ability to speculate, or hedge interest-rate risk, in a relatively conservative and comfortable manner.

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