Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Six-Month Eurodollar Curve
Transcript
- Lucas: There's a corner of the interest-rate market that the Fed watches more closely than most people realize, and right now it's sending a pretty specific signal. Luna: Which corner are we talking about? The two-year? The ten-year? Lucas: Not Treasury yields at all — the six-month Eurodollar futures curve. It's less glamorous than the yield curve, but for central bankers it's almost like a diagnostic tool for how monetary policy is actually transmitting through the banking system. Luna: Okay, so let's define that. Eurodollar futures are essentially bets on the three-month dollar interest rate in London, right? Not on the fed funds rate directly. Lucas: Exactly. They're tied to the three-month libor replacement rate, which is now sofr based, but the contract structure is the same. And the six-month point — that's the one that captures the expected path of short-term rates over the next two quarters. It's more forward-looking than the spot fed funds rate, but shorter-dated than the two-year Treasury. Luna: So it sits right in that sweet spot where policy expectations and actual bank funding costs meet. Lucas: Right. And here's the current picture. The fed funds rate is at 3.63 percent, effectively unchanged since June. The ten-year Treasury is at 4.48, up about 11 basis points in the last week. But the six-month Eurodollar futures curve has flattened dramatically — the spread between the nearby contract and the contract six months out has narrowed to just 12 basis points. Luna: That's tight. So the market is pricing almost no change in short-term rates over the next half year. Lucas: It's pricing a very small probability of a cut, and effectively zero probability of a hike. That's a big shift from April, when the curve was pricing in about 40 basis points of easing by year-end. The June payrolls miss — 57,000 jobs added — should have pushed that expectation higher, but instead the curve flattened. Luna: Why? That seems counterintuitive. Weak jobs number usually boosts rate-cut bets. Lucas: Normally yes. But the market is also looking at the labor force participation rate, which fell to its lowest level outside the COVID era. That's a supply-side problem, not a demand-side collapse. The Fed can't cut rates to fix people who've stopped looking for work. So the market is essentially saying: the economy is slowing, but the Fed's hands are tied by structural labor shortages. Luna: And the six-month Eurodollar curve is the place where that tension shows up most cleanly. Lucas: It becomes a kind of credibility gauge. If the market believed the Fed would cut soon, the six-month futures rate would be lower than the current fed funds rate. Instead, it's almost exactly in line. The curve says: the Fed says it's holding, and we believe them. Luna: That's interesting because historically, the six-month Eurodollar curve has been a leading indicator of actual FOMC moves. I remember reading that it flattened like this before the 2019 pivot, and before the 2023 pause. Lucas: It's one of those market signals that tends to anticipate the Fed by about three to six months. In 2019, the curve flattened and then inverted at the six-month point about four months before the July cut. In 2023, it flattened and stayed flat for five months before the Fed actually paused in September. Luna: So if this flatness persists, it might be a signal that the next move is a cut — just not anytime soon. Lucas: That's the baseline interpretation. But there's a nuance. The six-month Eurodollar curve also captures dollar funding stress. If European banks are having trouble sourcing dollars, that can push the futures rate higher independent of Fed expectations. Luna: And that's relevant right now because of what's happening at the ECB. Lucas: Exactly. Last week, Christine Lagarde left the door open to an early exit, which the market read as a potential rate cut sooner than expected. That could weaken the euro and increase demand for dollar funding from European institutions. Which in turn puts upward pressure on Eurodollar rates. Luna: So the curve might be flattening partly because of Fed hold-steady expectations and partly because of ecb driven dollar demand. Lucas: And the Fed is watching that distinction carefully. Because if the flatness is driven by funding stress, that's a different policy signal than if it's driven by a genuine belief that rates are on hold. The Fed has more tools to address funding stress — like the standing repo facility — but if the market just thinks the Fed is credible, then that's a sign that policy communication is working. Luna: Which one do you think it is right now? Lucas: I think it's a mix, but leaning toward the credibility story. The ten-year breakeven inflation rate is at 2.24 percent — basically right at the Fed's target. The core PCE is at 130.1, up only slightly from last month. Inflation expectations are anchored. The labor market is tight but not overheating. The Fed has been saying 'higher for longer' and the market is finally listening. Luna: So the six-month Eurodollar curve is basically a report card on the Fed's forward guidance. Lucas: It is. And right now, the report card says: A-minus. The market gets it. They're not fighting the Fed. But the risk is that if the curve stays flat too long, it might start to signal that the economy is softening more than the Fed realizes. And then the next move could be reactive rather than preemptive. Luna: Speaking of the podcast's own forward guidance — you know, we keep this show free of ads, and that's something we deliberately choose to do. Lucas: Yeah, we hear from listeners that they appreciate not having a mortgage ad interrupt a conversation about the yield curve. If you find value in that, and you want to support the work, the link is buy me a coffee dot com slash fexingo. No pressure, just a way to keep it sustainable. Luna: Exactly. It's a small gesture that makes a big difference for us. And we're grateful to everyone who's already chipped in. Lucas: Okay, back to the curve. One more data point I want to bring in — the three-month Treasury bill is yielding 3.69 percent, about 6 basis points above the fed funds rate. That's a normal premium for a risk-free asset, but it's actually on the low side historically. Luna: So that reinforces the message that there's no panic in short-term funding markets. Lucas: Right. No one is scrambling for liquidity. The Fed's interest on reserve balances is at 3.65, and the effective fed funds rate is 3.63 — right in the target range. The plumbing is working. Luna: But if the six-month Eurodollar curve is the diagnostic, what's the prescription? If you're on the FOMC, what do you take away from this? Lucas: I think the takeaway is: don't rush. The market is already doing the work of tightening financial conditions for you. The flat curve means banks are reluctant to lend at longer tenors, which slows credit growth. The Fed can afford to wait and see whether the labor market stabilizes or deteriorates further. Luna: And if the curve starts to steepen again — if the six-month rate rises above the fed funds rate — that would be a different signal. Lucas: That would mean the market expects a hike. Or it would mean dollar funding stress is spiking. Either way, the Fed would have to react. But for now, the flat curve is a sign of equilibrium. It's not exciting, but for central bankers, boring is beautiful. Luna: So the next thing to watch is the July FOMC minutes, and whether the committee references Eurodollar futures at all. They usually don't, but if they do, it'll be telling. Lucas: They might not mention the specific contract, but they'll talk about 'market-implied policy expectations' and 'financial conditions.' That's code for what we just walked through. The six-month Eurodollar curve is the engine under the hood — you don't see it in the dashboard, but it drives the car. Luna: Alright, so next episode, maybe we look at the two-year swap spread and see what that adds. Lucas: I like that. It's the other piece of the puzzle. The swap spread tells you about counterparty risk and bank health. But we'll save that for next time.