Fire All the Central Bankers While There's Something to Salvage
Eurodollar futures contracts are cash settled using an index tied to 3-month LIBOR. Therefore, it can pay handsomely to figure out where 3-month LIBOR will be at specific points in the future. Since LIBOR is a US$ short-term interbank rate, it is going to be heavily influenced by the Federal Reserve.
The Fed can offer alternatives which is why LIBOR most times tends to follow along with the US central bank’s monetary policy targets. Jay Powell’s group can lend and borrow at whatever interest rates they set providing US$ money market participants dependable substitutes.
The key to figuring out where LIBOR will be in the future starts with thinking about where the Fed will be. But this is somewhat misleading; it sounds like you should just follow along with the central bank’s projections making only minor adjustments along the way. Place your bets/hedges based solely on the dot plots and then forget about the contracts until expiration.
Except, no, consistent with the last dozen years, more often than not Jay Powell like his predecessors doesn’t have a very good idea himself. The FOMC’s guesses for monetary policy targets haven’t been very useful.
In late 2018, for example, monetary officials believed that the economy was robust or at least putting together sufficient positive factors so as to warrant further rate hikes in 2019. If the unemployment rate proved a useful guide, then perhaps even more rate hikes than in 2018.
As far back as June 2018, though, the eurodollar futures curve had inverted; that is, at key forward contract positions along that curve the market began to price/hedge for falling LIBOR. It was a warning sign that money market rates were not going to go the way Jay Powell and the FOMC were thinking.
Obviously, that’s just what happened. This curve inversion accelerated beginning in November 2018 which just told Powell the market was increasingly certain he was all wrong. After hemming and hawing, first hitting the pause button while reassuring Americans the US economy wouldn’t need them, it took him another three-quarters of a year to finally prove eurodollar futures right when finally cutting his policy targets.
The market knew long before policymakers at the Fed what policymakers at the Fed were going to do. Shades of 2007.
Going back to our original premise, the key to making money in eurodollar futures is to push past all the official bluster and the emphatic repetition of the mainstream narrative (which is actually quite easy when there are huge sums of money on the line). It’s not about what Jay Powell says today the FOMC is going to do tomorrow, rather it’s about the state of the world tomorrow regardless of what Powell says today which will force the FOMC into one action or another notwithstanding policymakers’ willingness.
Though very few are aware of this market for eurodollar futures, it’s among the biggest, deepest, and most sophisticated in human history. It doesn’t suffer fools (like Fed Chairs) and contains tremendously valuable information and forecasting power.
There are, right now, about 1.6 million contracts open for the June 2020 maturity. Each contract represents a hypothetical $1mm eurodollar deposit, therefore that open interest equates to $1.6trillion notional. And that’s for just the one contract. There is an unthinkable amount of market power all focused on determining the relevant factors governing the behavior of 3-month LIBOR.
US central bankers from Ben Bernanke and Bill Dudley on down to Jay Powell and whomever the latest Open Market Desk flunky might be refuse to listen to the eurodollar curve because this one market quite often embarrasses them. It predicts to the world how and when they will be dead wrong. Being an FOMC member means you never have to confess how this is true.
Going back to early June 2019, the eurodollar futures curve had continued to stick its finger in Jay Powell’s eye. As he was getting ready for his first rate cut, the curve had inverted so much the last time it had been in such an upside down state was in the summer of 2007. At the time, I noted (in a tweet) how the curve on August 9, 2007 (the day Global Financial Crisis #1 began), was inverted about 50 bps from the front month to the June 2008 contract.
On June 3, 2019, the eurodollar futures curve front month to June 2020 had been inverted by 76 bps.
In other words, this market was more certain about the downdraft coming in LIBOR, meaning rate a whole series of rate cuts to Fed targets, in the middle of 2019 than it had been in the summer of 2007!
But coronavirus, they’ll say. There’s no possible way anyone in June 2019 or even January 2020 could’ve predicted what’s going on now. Jay Powell keeps claiming the economic and financial fundamentals were at least good if not totally awesome right up until COVID-19 cost the life of the first American.
And, once again, he’s absolutely wrong.
In the summer of 2007, eurodollar futures investors weren’t actually that much focused on subprime mortgages. The concerns which had inverted the curve back then were more systemic in nature; they had to be in order to get to a point where the market was pricing a huge chance of so many rate cuts that by June 2008 3-month LIBOR would be substantially lower in nominal terms.
That’s really what was spooking the market – systemic frailty and the growing probability for a full-scale meltdown. Subprime mortgages had only begun to reveal all the weaknesses and chokepoints that eurodollar futures investors understood, unlike Ben Bernanke and his FOMC.
Contrary to popular belief spun by self-serving central bankers already at war with the eurodollar market, the global monetary system last year was becoming increasingly and more outwardly troubled. There were any number of warning signs, each of them documented in detail right here, and each one dismissed in turn by publicly confident central bankers who in private were probably worried beyond description.
There were fed funds, interest rate swaps, and the absurd dance around IOER. Then September’s repo rumble. Collateral, not bank reserves.
Combined, it all screamed out SYSTEMIC FRAILTY!
And that’s just what the eurodollar futures curve began to price around mid-year 2019. The chances of another big break were growing. If it wasn’t coronavirus, which, admittedly is a big one, then it would likely have been something else. The system was already in an alarming weakened state long before the first hidden case of COVID-19 popped up behind the darkened curtain in Wuhan.
Like 2007, this market (as well as other parts of the entire “bond market”) had been factoring what Jay Powell would do when faced with a situation he had to take more seriously - unlike his response to September repo. ZIRP and QE, the asset purchase plans which would get expanded to include other kinds of assets.
These have all been anticipated, priced, and probabilities of success, or failure, discounted into the futures contract prices all up and down the curve. All focused on where will 3-month LIBOR can be.
Which brings us to today’s curve, and what is shaping up as another 2008 oddity. The thing is not a singular whole; you can draw a single line for it, of course, but the factors driving pricing behavior at the short end might not be the same as those being considered further down. There can be a significant difference short run to long-term across a single curve.
That’s what we see right now. The long end of the eurodollar curve continues to be compressed. To put it simply, near-zero 3-month LIBOR for the foreseeable future beyond the short-term.
While that sounds like the market is on the same page with Jay Powell, it already isn’t. Over the past couple weeks US QE has been expanded into the biggest QE ever, along with the re-introduction of too many GFC1 crisis programs to count, and yet if the market thought these would be successful, you’d see the long end eurodollar futures contracts selling off.
They aren’t; it’s actually the short end where there is selling is right now. A double dose of bad news, the market once again predicting for the world Jay Powell’s embarrassing failure.
That failure centers around the central bank’s whole purpose, which is currency elasticity. Forget the full employment or inflation mandates, those were tacked on by politicians in the wake of two of the Fed’s biggest disasters (the Great Depression and the Great Inflation, respectively). Behind those is currency elasticity. During the thirties, the US central bank failed to keep the money stock sufficient (deflationary currency inelasticity) while in the seventies it didn’t keep it under control (inflationary currency over-elasticity).
But since the seventies, central bankers haven’t been able to define and measure the money stock with any sort of vague idea let alone precision. In fact, one of the key reasons for the Great Inflation (and I would argue it was a primary reason) was this monetary evolution.
Policymakers in the eighties believed they had solved their deficiency by shifting from a regime focused on money to one devoted to managing expectations exclusively. The FOMC would move around a single short-term money rate (federal funds target) in order to indirectly influence behavior (depending a whole lot on this becoming a self-fulfilling prophecy; monetary policy works only when everyone believes it works).
In order for the illusion to take hold, however, this would require other money rates becoming attached to the single policy rate. Something like LIBOR needed to move in tandem with the monetary policy target for fed funds.
And that did happen – until August 9, 2007.
On that day, LIBOR and the effective fed funds rate shot upward well above the policy target putting the whole world on notice. The following day, the two actually diverged; LIBOR would remain high and above while fed funds too often would plunge downward significantly below the FOMC’s goal.
Confusion reigned inside and out. At the central bank, policymakers kept thinking there was too much money during a global monetary panic. They couldn’t make sense of extremely low federal funds, ignoring extremely high (in relation to the policy target) LIBOR. The spreads, which are what matter, were too positive for eurodollar markets and way, way too negative for fed funds (as well as GC repo).
Ben Bernanke’s crew kept trying to “soak up” what they all believed was an “excess” of monetary reserves – all during fire-sale, liquidation conditions across global markets.
The problem lay in the shadow parts of these money markets that nobody can really see except those on the inside (who just so happen to be the same people trading eurodollar futures).
The effective federal funds rate isn’t a single rate at which everyone in the federal funds market borrows and lends. It is a weighted average of many transactions which take place across a wide range of interest rates.
LIBOR, by contrast, is a survey conducted by the British Bankers Association querying certain large banks operating in London’s offshore dollar (meaning eurodollar) market. It is not based on actual transactions, rather it is derived as an average of what rate those banks say they would lend if they were to lend in this arena; whether they do or not.
For that reason, as well as the cheating scandal, global officials have moved to remove LIBOR from the financial system. That global system, however, is having none of its so-called replacement, SOFR (which combines repo, fed funds, and other transactions into a single whole purportedly describing general conditions for all of them).
What policymakers still don’t seem to understand is that a money rate derived from only the transactions which take place – the supposed strength of SOFR - can be hugely, disastrously misleading.
Take, for example, fed funds. If a certain subset of borrowers begins to be perceived as weak or riskier, then we would expect cash lenders to increase the rate at which the lesser quality borrowers will be charged. The weighted average for fed funds, the effective rate, would rise indicating this concerning shift.
But, if this was taken to an extreme, as in August 2007, cash lenders might begin to shun those weaker participants entirely; lending their surplus cash instead to the sturdier institutions remaining. In fact, those strong borrowers in the market would be left to choose from an overflowing surplus of lending offers driving their own costs down substantially.
In that market circumstance, what happens to the weighted average? Effective fed funds would fall because there is less activity at the top end of the range as more and more of the “weak” group get completely shut out while at the same time cash lenders dump everything they can upon the shrinking group of “safe” borrowers at lower and lower rates.
The falling fed funds effective rate becomes hugely misleading.
There’s a similar situation for repo, where a collateral shortage leads to lenders dumping all their cash on only a small group of borrowers who can post the acceptable collateral. Here, too, the actual transactions in the market push the repo rate down giving off the exact wrong idea of liquidity conditions.
Compared to fed funds or repo, the surveyed banks of LIBOR are giving out rates based on where they might lend if they had to lend even to the weakest ones, whether or not they would actually lend to anybody.
Believe it or not, and given how badly things have gone this month you might be more likely to believe anything, we’re right back in this same situation. Over the past week, in particular, the effective federal funds rate has been dropping and I mean spreads not rate cuts. GC repo rates are even lower.
Where is LIBOR? Shooting upward. As of yesterday, 3-month LIBOR was 1.35% compared to effective fed funds of 0.10% and GC repo (UST) at 0.09%. SOFR was practically zero. While 1.35% 3-month LIBOR may seem low, too, it’s not in terms of spreads; this is an enormous difference, and enormously consequential when it comes to global US$ liquidity. Inelasticity, in other words.
How huge? The TED spread, that is, the difference between 3-month LIBOR and the 3-month T-bill yield, has blown out to the highest since GFC1 surpassing even 2011. Since TED is a measure of credit risk in the interbank markets, it is telling us something important about Jay Powell as well as those falling fed funds and repo rates.
It's not working, Jay. Despite all the QE’s and the alphabet soup of bailouts, high and rising (up nearly 11 bps on Thursday alone) LIBOR relative to low and sinking fed funds or repo is a huge warning sign about the current state of the monetary world.
And the selloff in the front end of the eurodollar futures market declares that it may stay this way for some time! These contracts are beginning to price out a scenario where LIBOR diverges in very 2008 fashion for a prolonged period of time regardless of the Fed’s asset purchases and how much they diddle with overseas dollar swaps. Sustained inelasticity, in other words.
If the central bank is supposed to instill currency elasticity in order to keep a crisis from spiraling into a much worse situation, then the Fed is once again failing at a very critical, perhaps monumental moment in 21st century history.
That’s what will ultimately matter here. The coronavirus was a no-win scenario; it was going to create a serious dislocation no matter what. Central banks, though, are kept around for this very situation. To keep the downside as short as possible, maintain the monetary and financial systems in working condition so as to limit if not contain the potential for long run damage.
And that’s where the long end of eurodollar futures come back in. The market is saying at its front the Fed’s current activities aren’t having enough, or any, short run positive effects. The back end of the curve is saying that because of the Fed’s failures this will mean long run damage to the US and global economy way over and above the temporarily severe shutdown due to the government’s pandemic response.
It's entirely unnecessary, too. Both ends of the eurodollar market have seen all this before; it was never really subprime mortgages. GFC1 went totally over the heads of clueless policymakers (there are too many reserves to soak up!) which resulted in a paradigm shift, and not a good one, for the whole global economy thereafter. The last decade had been called secular stagnation because that’s the best anyone could come up with for it.
Rather than learn a damn thing from that first go ‘round, central bankers were therefore completely unprepared for this second. The eurodollar futures market, by contrast, has been especially prepared for the Federal Reserve to screw it all up all over again. And right now, it is preparing for the screw ups (systemic inelasticity) to last significantly longer than they should, the long run damage to be run up to so much more than necessary.
The very definition of corruption: dishonest or fraudulent conduct by those in power.
Fire them all! Immediately, while we still have some chance to salvage something.
