The Federal Reserve’s mass purchases of Treasury bills are creating distortions in money markets and that may make it harder for Eurodollar traders who bet on the interest-rate outlook.

What started as an attempt by the Fed to relieve strains in money markets is having an unintended impact on some of the world’s most important borrowing benchmarks.

As the central bank started buying $60 billion worth of Treasury bills monthly from last October, yields dropped. The three-month London interbank offered rate for dollars followed the decline.

When that happened, the gap between Libor and overnight index swaps -- a proxy gauge for fed funds rates -- started to narrow. The spread last week narrowed to 13 basis points for the first time in three years and it remains close to that level. Morgan Stanley predicts it may even turn negative for the first time.

All this means life may get harder for traders of Eurodollar futures, who place wagers on the Fed’s interest-rate outlook. These contracts are based off three-month Libor, rather than the fed funds rate, and movements in this spread can turn winning trades to losers.

Traders of Eurodollar futures were similarly thrown off guard last August. Back then the reverse happened, as the Libor/OIS spread widened sharply, reflecting a failure to keep pace with the dovish repricing of Fed expectations when overnight swap markets dropped.

This time round, the Fed’s purchases of Treasury bills at a time when supply is dropping is leading to a tightening of the spread.

The U.S. central bank will buy $333 billion of T-bills in the first half while net supply drops by $44 billion, resulting in a $377 billion decline in privately-held bills, according to Morgan Stanley.

“We expect T-bills to richen substantially in 2Q,” strategist Kelcie Gerson wrote in a Feb. 14 note.

Negative Spread

In the second quarter, companies are also expected to plow tax refunds into prime funds, which tend to buy corporate papers, Gerson wrote. The combined impact could see the T-Bill/OIS spread drop to minus six to eight basis points, potentially making the Libor/OIS spread negative, she said.

Morgan Stanley is recommending that investors hold trades that see June FRA/OIS tighten relative to September.

Bank of America Corp. also expects the Libor/OIS spread to tighten further, perhaps to “high single digits,” although it doesn’t see it turning negative.

Any move lower is unlikely as “investors would likely prefer to shift into bills or government money market funds versus taking credit risk without adequate compensation,” Mark Cabana, BofA’s head of U.S. interest rates strategy, wrote in a Feb. 13 note.