A negative interest rate policy (NIRP) is another tool at the disposal of the Federal Reserve to stimulate the economy. You can take a deep dive into NIRP through a quick Google search, but for our purposes NIRP simply encourages spending and borrowing. Banks would charge a fee to hold savings and borrowing costs would be at never before seen lows. The Fed would fight deflation by discouraging savings and incentivizing spending. It’s not an unprecedented policy. The European Central Bank turned to negative rates in 2014 to combat the Eurozone crisis. The Bank of Japan adopted NIRP in 2016. Neither has returned to positive rates.
What Does the Market Think?
The Eurodollar options market started to look at the possibility of NIRP in early May. During the last period of low rates from 2008-2015, the typical target in Eurodollar futures was the 99.75 strike. This would indicate a Fed Funds effective rate or around 12.5 basis points (bps) and TED Spread rate of about the same (100.00 – 12.5 bps Fed Funds – 12.5 bps Ted Spread = 99.75). The 99.875 strike would actually represent a rate of 0 bps to slightly negative. Therefore, the 100.00 strike and higher would be active in a NIRP environment.
Over the 2 weeks from May 4 to May 15, open interest in the 100.00 to the 100.50 strikes from EDU0 through EDM1 increased over 250,000. We’ve seen trades in the 100.00 strike and higher in the past, but typically they were sold in a package to finance the purchase of lower strikes. Not the case here. We were seeing short covers of the 99.875 and 100.00 calls and new longs being established. In addition, 170,000 of that new open interest is in the EDH1 and EDM1 contracts. That’s a long way out.
Of course, following this surge of activity, Fed Chair Jerome Powell appeared on 60 Minutes and declared that NIRP isn’t a tool that the Fed is considering at this time. Almost immediately interest in those strikes above 100.00 dried up.
What to Look For
Looking at Fed Funds futures, anticipation of NIRP will be quite obvious. Anything above 100.00 would indicate negative rates.
We saw indications of this in the December 2020 contract (ZQZ0) in early May. As you can see, this corresponds to the previously mentioned activity in Eurodollar options. The Fed Funds futures lagged by a few days, but that’s not surprising given that Eurodollar futures are much more liquid and active.
With regards to the Eurodollar options, be on the look out for declining open interest in the 99.875 and 100.00 strikes. We typically see these strikes used to finance the purchase of calls that are closer to at-the-money or as the end leg of call fly, for example. Closing out those strikes would indicate a change in opinion about the rate at expiration. For example, we have seen many 99.75/100.00 call spreads bought across multiple expirations. If a holder of this call spread thought NIRP was on the horizon, they may purchase the 100.00/100.25 call spread to widen out their existing position (a 99.75/100.00 call spread would become a 99.75/100.25 call spread). Therefore, you would expect to see a decrease in the 100.00 call open interest and an increase in the 100.25 call open interest. And, of course, any new open interest in the 100.00 strike and higher, much like the activity we saw in early May, would be a good indication of a change in sentiment.
The Fed doesn’t see NIRP as a viable tool at this time, but that doesn’t mean it can’t be used in the future. And there are plenty of examples of the market seeing the signals before the Fed. While the activity in early May was a bit early, at least you know what to look for going forward.