I could probably file this as Understanding Eurodollars, Part 4 as an extension of my earlier series on the subject, but, since this is intended more for analysis than discovery of the underlying dynamics, its seclusion is at least warranted. Because the eurodollar market is mostly a mystery, assuming people have heard of it at all, there is an assumption that it is a secondary or tertiary market. This is blatantly false. First and foremost, the eurodollar market is the bastard left over from the remnants of the gold exchange standard. It was the epicenter of the 2008 panic and remains the hub of (unfortunately) global finance and trade.

Second, the eurodollar market is massive. It is not only the flagship product at the CME, there are trillions in dollars positioned for interest rates and curve dynamics. It is the entry point into global credit, and perhaps even the control valve for all of it.

Each contract on the CME is standardized as future delivery of $1,000,000. Structurally, the futures contracts are spread among quarterly maturity dates (Mar, June, September, December). As these front months approach, interspersed months appear only for the next period in case institutions need more maturity precision. By and large, however, trading is relegated to those benchmark months – packs and bundles of all colors refer to these standard months.

As of this morning, the open interest in each of the benchmark months out to 2021 is as follows:

ABOOK Dec 2013 Eurodollars Open Int Contracts

As you can see clearly, by far most of the “money” congregates to around 2016/17, or about 2-3 years down the curve. There are over 1 million contracts outstanding for the December 2015 maturity alone, or 2-year money.

ABOOK Dec 2013 Eurodollars Open Int Dollar Volume

If we change the scale from purely the number of contracts to implied dollars, we see that there is more than $1 trillion slated for delivery on the expiry of the December 2015 contract. There are numerous benchmarks with at least three-quarters of a trillion dollars outstanding.

That provides the context for what occurred after May 1. The Fed and Chairman Bernanke in their rush to “convince” the markets and economic agents that QE was working so well it needed to be tapered actually began to crush the “money” part of the eurodollar curve.

ABOOK Dec 2013 Eurodollars Volatility 2

Shorter maturities blew wider along with the rest of the curve. But where there was only hundreds of billions at the far maturities, inside the 3-year window lay about $7.5 trillion in accumulated contract deliveries. That was enough of a disturbance to throw the whole of the credit markets into near total dysfunction, including the mortgage bond market.

Under the September FOMC “cover” of forward guidance is not tightening, the FOMC re-established some measure of calm in the “money” window. However, that is only in comparison to the drastic action of the summer. There continues to be selling/tightening in that “money” part of the funding curve.

ABOOK Dec 2013 Eurodollars After Taper

As you would expect, as the entire treasury/rate complex has been selling the overall shape has been toward flatter. That reverses the dramatic steepening seen in the months leading up to November 20 (and whatever happened in the swaps market that day).

ABOOK Dec 2013 Eurodollars 5s10s Flattening2

Again, that makes intuitive sense when given the context from above. As the Fed sought to re-assure the shorter ends, there was less volatility, and thus selling/tightening, in the shorter ends than the longer (where credit is more sensitive to other factors). Since early December when funding markets started to see more volatility throughout, that has flipped back as selling has been amplified in the “money” window.

That would seem to suggest a partial rejection of forward guidance. It is only partial because the absolute pace of the tightening trend has been tamer than the mid-year episode – at least to this point. In other words, volatility in the spaces where the most money is on contract is, so far, much less by comparison.

But there is volatility there, and that is the larger point here. There are trillions and trillions at stake and the taper drama is bound to cause more than a little general tightening (as the knee-jerk reaction to taper seems to be coalescing into that). Volatility in funding almost guarantees it, no matter how much policy advocates loudly express their disapproval. As the curve flattens with a 10-year treasury anchored around 3% (and higher), we will see how much these other secondary markets react.

 

Click here to sign up for our free weekly e-newsletter.

“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: jhudak@4kb.d43.myftpupload.com or 561-686-6844 . You can also book an appointment for a free, no-obligation consultation using our contact form.