Whatever bearishness existed prior to December, credit markets clearly shifted beyond to a heightened state of concern. That was not lost on the FOMC internal discussion regardless of what they state publicly, as the action in credit has taken now to levels unmatched by anything seen in the past five years – and it’s not like the past five years have been uneventful. The primary pivot, in terms of how monetary policy reflects and supposedly affects the real economy, is “inflation.”

ABOOK Jan 2015 Eurodollars Inf Breaks

The 5-year breakeven has fallen below the low point in 2010, meaning the only comparison now is 2009 (the 10-year is sitting right at that 2010 low). The FOMC says pay no attention as this is just “transitory” and the big economic boost is just around the corner, but the fact is that breakevens haven’t been seriously “optimistic” since March 2013. That month isn’t striking in anything other than dealer repositioning in swaps and funding markets ahead of Bernanke’s taper threats (the discussion about the significance of March 2013 is here).

Because of that timing, I think funding markets are actually leading what is taking place in the broad credit spaces. Even the changes in credit in December, I believe, can be traced to perceptions in funding.

ABOOK Jan 2015 Eurodollars Curve December Shift

The eurodollar curve, for example, has faded flatter in much the same manner as the UST curve. That is important as it reflects the battle the Fed is trying to fight in getting credit markets to see finance and the economy on its terms. For all the supposed and assumed posturing by monetary policy, including, as everyone seems to miss, the end of QE, the eurodollar curve is less than impressed by any of it. While stocks may rise and fall on the slightest hint of the end of ZIRP or not the end of ZIRP, funding markets seem actively stuck.

If you compare open interest in eurodollars, what becomes clear is the shift in the “money part” of the curve as the calendar rolled forward.

ABOOK Jan 2015 Eurodollars Curve OI

Overall open interest has increased in the past year, but positioning has remained heaviest in the 2015 maturities (rather than rolling forward with the calendar into generic 1-year tenors). That would suggest, highly, that “investors” are most concerned about 2015 rather than just the 1-year time premium (in contrast to what the FOMC is trying to rationalize about why credit markets are so defiant). Look at the open interest in the years thereafter – significantly less comparing 2-year and 3-year maturities.

What that looks like, to me, is a “market” that thinks there is relatively more clarity on 2015 and far less in the years immediately thereafter (where the curve “should” be moving toward the FOMC’s view on inflation, economy and everything else). That “clarity”, if this is correct, however, returns somewhat in the outer years. In simple terms, it seems as if eurodollar funding sees a high probability that the Fed will raise rates this year, very much unsure about what that will do in the immediate term, and far more assured that it will not be good long term.

That stance is not a knee-jerk reaction to December, either, as outer calendar spreads have been falling ever since November 20, 2013.

ABOOK Jan 2015 Eurodollars Curve Calendar Spreads

Since the October 15 event, even the near-term calendar spreads have compressed noticeably, right in that zone of “unsure”, which suggests further that though the Fed may be committed to ending ZIRP there is at least a non-trivial possibility that commitment wavers or does not last very long.

The significance of trading in December and early January is nothing more than the hardening of those doubts radiating from funding markets (which includes persistent repo disruption and the failure of the Fed to do much about it or its determination toward a hard rate floor).

ABOOK Jan 2015 Eurodollars UST Broad CurveABOOK Jan 2015 Eurodollars UST 5s10s

Economic irregularities, such as recession, do not require financial irregularities as a precedent, but the appearance of financial irregularities is far more likely to involve economic disruption. That is an asymmetry in risk that I think credit markets, through funding market position, have incorporated. If March 2013 was the beginning of the paradigm shift, that was a repo event in the context of QE-driven imbalance in swaps and elsewhere. In other words, funding markets sensed that exits were impossible without disorder, and have picked up economic weakness as a baseline into which that disorder may play out.

The drumbeat of that downbeat has only grown since there has been nothing evident to assuage any of these concerns, a fact that the FOMC and orthodox economists have admitted (no wage growth) but simply wish away with “transitory” language. From the beginning, there was widespread understanding even inside the policy apparatus that monetary imbalances would be problematic but that a good and robust recovery would be more than a net gain to allow orderly rebalancing. Since the early part of 2013, only a few months into QE3 & QE4, these markets have essentially doubted that occurrence; doubts that have only intensified as the Keystone Cops of the FOMC point to a recovery that isn’t there and adjust very real policy first as if to make the imaginary tangible. This is very reminiscent as policymakers make mistake after mistake in perfect reflection of exactly how they operated from 2006 onward.