Trends in Eurodollar and Fed Funds Liquidity

While a zero-interest-rate monetary policy may have helped to get the economy back to its feet, it left the short-term interest rate market flat on its back. Then in February 2010, Federal Reserve Chairman Ben Bernanke announced plans to exit this strategy. Other factors, including the implementation of market maker programs and new technology, have served to support interest in CME Group Eurodollar futures and Federal Funds futures products.

Liquidity measures tend to focus on width and depth of market. Market width may be quoted in ticks or in dollars for orders of a given quantity and market depth may be measured in contracts at different levels in the limit order book.

CME group research shows liquidity in interest rates was down slightly in the second quarter of 2010 from very strong levels in the previous quarter of 2010. The change was attributed to the increase in volatility across many market classes during the second quarter as a result of the European debt crisis and concerns that a double-dip recession may be approaching.

Helping support liquidity in CME group interest rate products were market maker programs implemented by the exchange, as well as new technology that allows for electronic trade of complex options trades and spreading. These programs were put into play between 2005 and 2008.

Thomas di Galoma, head of U.S. rates trading at Guggenheim Partners LLC, contends that there will likely be some pressure in front rate products going forward. Because they have been low for so long, the market will likely see a significant flattening of the yield curve. He foresees a deflationary environment continuing through 2011 in the United States and believes the Japanese investor base is keen on the same deflationary theme, as they have seen similar trends in Japan over the last 10 to 12 years.

When Federal Reserve Chairman Ben Bernanke testified before the Senate Banking, Housing and Urban Affairs Committee on July 21, 2010, he told senators that the economic outlook was “unusually uncertain,” sending shock waves through the equity market.

Many institutional investors currently believe the Federal Reserve will raise interest rates during the second or third quarter of 2011. The futures markets also reflect those sentiments. As of late July 2010, CME Group Fed Funds futures were pricing in about a 76 percent chance of a 25 basis point hike sometime before July 2011.

Mary Sirois, a market maker in CME Group’s Fed Funds futures, expects that when the Federal Reserve begins to move, trading will become active in a number of contract prices. CME Group data showed that as of June 2010, the majority of liquidity in Fed Funds Futures could be found in the near-term months: June 2010, July 2010 and August 2010.

“When the Fed’s moving, we’re rocking too,” says Sirois.

It is all relative though. CME Group research shows that in the bigger picture, trading has been strong in short-term interest rate products. Volume in CME group’s benchmark Eurodollar complex was up 39 percent through the end of May compared to the same period in 2009. And in the 30-Day Fed Funds complex futures were up 80 percent with options up an impressive 195 percent.