Look at the Euro-dollar market dating to the Lehman Brothers crisis of September 2008; with the exception of a few (but not many) corrections, the Euro-dollar has been in a bull market.
After observing hundreds of billions in stimulus programs and quantitative easing being poured into the economy, the Euro-dollar market has consistently failed to price in where interest rates will be in the future, always attempting to factor in a rate increase that doesn’t materialize. Why? The market insists on calculating interest rate increases relative to growth based on traditional time frames, which have always responded to monetary policy.
In this case the economy has not had a sustained response to the Fed’s easing of QE1 and QE2. After each quantitative easing the GDP has slipped back toward recessionary levels. Recently the Economic Cycle Research Institute (ECRI) announced a new recession has already started. According to The Economist, ECRI has never issued a false alarm, sourcing David Zeiler, the associate editor of the “Money Morning” financial blog.
During his Congressional Testimony of 4 October 2011, Fed Chairman Ben Bernanke offered a grim assessment of the nation’s economic health, telling the Committee that the “recovery is close to faltering.”
The bias in this market is its inability to price in the output gap – the difference between GDP and potential GDP. If the U.S. is growing at 2% and potential GDP to achieve price stability and bring down unemployment is 5%, then there is a 3% gap. With the economy possibly tipping back to recession levels, the output gap will likely take some years to close, thus leaving current interest rates where they are, even beyond the Fed’s promise of 2013. If one looks at the 2014 through 2016 contracts in the Euro-dollar it will be observed that this market is once again factoring in unrealistically higher rates.
Investors might then consider taking a long position in E5U 98 call options (September 2016 Euro-dollar call option expiring September 2012).
Disclosure: writer is currently holding positions in E5U 98 call options.
