Below is the long term chart of the eurodollar (ED) yield, showing the effects of a decade of money printing and bubble blowing. In the last two years this has created what I have called the central bank or Wizard of Oz bubble. This bubble and all its correlated bubbles were caused by the willingness of central bankers to purchase, lend against and then hold trillions of dollars of overvalued securities. This bill of goods was sold as 'emergency measures,' and investors remain convinced that the mere 33 basis point interest rate reflected in the eurodollar market will and can be supported by a continuation of the emergency.
Conventional thinking is that purchases of inflated securities and money printing that goes with it are just business-as-usual instead of a freak show. In addition, it's assumed that trillions in kick-the-can-down-the-road private debt maturities, for sure trillions more of debt sovereign debt offerings, and maturities are on the way. Oz has a heavy burden to carry indeed.
The blowback to all this activity should be apparent to any thinking person: a bagunca (mess) of destabilizing global inflation starving returns of prudent savers down to nothing; real, defacto or implied bailouts of too-many-to-count toxic basketcases; and an incredible return of moral hazard behavior and speculation. Of course you are going to see artificial maladjusted economic activity from this, at least for a short while. It is all a trap.
The logical end of the line for horrific 'temporary emergency' policies will be a chain reaction of sovereign defaults, insolvencies, debt restructuring, and losses for bond holders . Although this hasn't happened formally, bondholders who bought 10-year Treasuries in Portugal eighteen month ago now have a 24% loss on principal. These are not reflected on bank balance sheets. Simply put, the yields on PIGGS sovereign debt (and elsewhere) are not about liquidity and confidence - they are about debt trapped insolvency.
Blow ups will come when players at various points along the daisy chain take big losses that can't be supported by the Wizard of Oz or governments. In fact Oz itself will suffer big losses once the Ponzi chain breaks. The uninitiated can start here (If Only PIGGS Could Fly) for an understanding of just some of the various candidates for sovereign defaults. Historically, because of the linkages, these will come in bunches.
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Eurodollars are foreign dollar deposits outside the U.S. banking system in foreign banks. Despite the name, these are not just European banks, although those would constitute the majority. Some are in the Middle East in places such as Bahrain (Forces Fire on Protesters). So in essence, eurodollars are dollar deposits in non-U.S. banks.
One contract tracks the 3-month London Interbank Offer Rate (LIBOR) on million-dollar offshore deposits. LIBOR is the rate that the commercial banks charge each other for overnight lending in the international market and is considered to be a global benchmark for short term interest rates. Contract specifications are laid out here. For risk management purchases, I would collaborate about $2,000 as the loss per contract, which would put the ED yield at 15 BP, and cover a month's carry.
So what would make this trade work? Traditionally it has traded as a Fed policy instrument; now it seems monopolized by it . When the Fed eases or is active, traders bid up EDs. Therefore if Oz is forced by the howls of inflation to climb off the cliff, or waffles on QE3, this market will sell off. If Oz (the Fed) actually moved to tighten, it will sell off even more so. Although I assign a higher probability of this happening than conventional wisdom, I am not counting on this element. As far as being inflation fighters, Oz has an incredible capacity to call inflation such as the MIT billion price survey 'temporary' or irrelevant just like their emergency measures were temporary. Regardless, once the party ends, Oz will permanently lose what little creditability it never should of had. That is another reason I don't see any market downturn as temporary.
But I digress, as the real appeal to this trade is not Fed-watching but elsewhere. How much lower can the ED yield go? Stranger things are happening, but will deposits stay in foreign banks if yields are 25 bp, or 20 bp? Bizzarro world at this stage is a manageable risk - it is not like we are dealing with 400 bp of downside to zero. Of course the trade might just sit there for a while, like watching paint dry.
However, in the short term I would point out a two day spike in emergency borrowings from the ECB, an event which in normal times with fewer Oz-induced comatose market participants would get more attention. More importantly though, are corporate CFOs and Treasurers sitting at their terminals with hair triggers ready to blow this popsicle stand (a bank run) once the wheels come off these European or Middle Eastern banks. It could just as easily be a state or local U.S. blowup that triggers it.
Who in their right mind accepts 33 basis points - Oz-backed returns in an insolvent banking system dependent on expensive government interventions? Numb to the risk, markets are counting on more bailouts and money printing in Europe, with estimates of 400-500 billion euros for the next round. In reality a lot could hit the fan over the next month. There is an election in Ireland on Feb. 25, and likely winners aren't bank friendly.
“We believe that Ireland may be left with no option, in the absence of a renegotiated deal, but to write down the value of the bonds in the Irish banks or face the prospect of a hugely damaging sovereign default”- Fine Gael, Irish Opposition Party, February 2, 2011
There are four German regional elections over the next month, and anti-bailout political sentiment is high. The last European meeting failed to reach consensus on a resolution mechanism. In the midst of it all a special eurozone debt crisis summit is scheduled for March 11th. And finally a boatload of debt is maturing in Europe over the next month.
Disclosure: I am short March eurodollars
Editor's note: Investors may want to consider the following international interest-rate ETFs as a proxy for eurodollars: IGOV, ISHG, BWX, BWZ
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