1. The US-German 2-year interest rate differential (swap rate) is a useful directional guide to the euro-dollar exchange rate. At about 105 bp it is the highest since 2005. The US premium had peaked in late 2004 near 185 bp. In the second half of the 1990s, it was not uncommon for the US premium to be in excess of 250 bp, It has risen 25 bp since the middle of October, encouraged by Draghi, whose dovishness again surprised investors.

2. The eurozone PMI confirms an irony. Economic data from the eurozone has held up well, pointing to fairly steady even if unimpressive growth. Draghi made a case for setting policy based on risk scenarios. The data does not seem to support such sense of urgency. At 52.3, the eurozone manufacturing PMI was slightly better than the flash (52.0) and is a little above the Q3 average. Of note, on a national level, Germany’s flash PMI was revised higher (52.1 from 51.6) and Italy was a pleasant surprise at 54.1 (consensus 53.1 after 52.7 in September). The service PMI may also surprise on the upside. Although the market has treated Draghi’s comments as if they were a commitment to ease policy at the December 3 meeting, it may not be a done deal.

3. Many still are unconvinced that the Fed will hike in the middle of December. Some argue against it on technical grounds. Raising rates in so close to the end of the year may inject extra volatility into the markets and complicate year-end activity. As a matter of fact, the Federal Reserve has taken action in the month of December. It hiked rates in December 2004 and December 2005, for example. It cut rates in December 2001 and December 1995. 

4. If one assumes that Fed funds which have been averaging 13 bp over the past 50 and 100 days continues to do so in the first half of December, and then after the rate hike averages 30 bp, then the December Fed funds contract is pricing in a 75% chance of a hike. Some assume that it will average the middle of the range, but besides the fact that it has been averaging around the middle of the range now, there is no compelling argument to assume this remains the case. Indeed, we suggest the possibility that in order to maintain maximum control, the Fed will want to provide sufficient liquidity to keep the Fed funds rate relatively low to ensure the attractiveness of one of the new tools in this cycle, the interest paid on excess reserves (which is the top of the Fed funds target range). It is true that know one really knows where Fed funds will trade after the hike, and we need to take the “odds” only in the contest of that assumption. My work suggest that the conventional measure may under-estimate the market-based probability of a Fed hike in December.