By Jeffrey Snider of Alhambra
A good part of the problem in analyzing modern money is that it is not a clear break from traditional understanding, but more so like radical evolution of it
The main policymaking body of the Federal Reserve, the FOMC, has had a tortured relationship with eurodollar futures during this past decade. As I chronicled here in greater detail, starting in early 2007 the committee members decided that the deepest, broadest market in terms of money in human history could not possibly reflect accurate expectations. Ben Bernanke had told Congress that subprime was contained, therefore there was no reason for Fed members to expect that they would be forced to reduce interest rates so soon after having stopped raising them (in name only, of course).
The episode reflected the growing divergence between what eurodollar futures were and are, and what they are “supposed” to be. To the FOMC, it alone will decide what short-term money rates are going to be, so eurodollar futures no matter how many trillions in open interest should never deviate so significantly from the official position. To Bill Dudley and the rest, they knew what was coming and it wasn’t anything to be much concerned about; to eurodollar markets, there were rising doubts about all that, those that over time proved correct.
A good part of the problem in analyzing modern money is that it is not a clear break from traditional understanding, but more so like radical evolution of it. Thus, the language and terminology is often imprecise, a fault that I am quite guilty of. I often use the vernacular of traditional monetary theory as a starting point, a frame of reference with which to introduce similar concepts in their evolved state (dollar vs. “dollar”). It often takes on a life of its own, leading to further ambiguity as terms themselves shift into a hybrid sort of shorthand that requires perhaps too much familiarity to easily comprehend.
Eurodollar futures, and certainly my own treatment of them, fall into this category. In the spirit of precision, they are not money, nor are they anything other than a temporal reflection of market expectations. It is quite easy to fall into a sort of laziness where eurodollar futures become interchangeable with money in analysis and discussion.But, by their very definition and contract terms, as a single contract gives the right to a $1 million eurodollar deposit balance for a three-month term at LIBOR, though they are integral to the monetary system they are not explicitly it. They are a future indication of money conditions as expressed via current circumstances, or at least the general and conventional perceptions of those circumstances.
It is for these reasons, the multi-faceted and multi-dimensional aspects, that I favor eurodollar futures as one of the most important, if not the most important, market indications for all that is hidden about what the global system, including economy. The history of the past ten years has been told in eurodollar futures, and told very well if you can translate them via these non-traditional terms. In fact, everything you need to know about the Great “Recession” and its entire ongoing aftermath is contained in just one chart:
I have segmented this select group of contracts into those under ZIRP (shades of red) and those longer that will fall under whatever counts as this end of “normalcy” (shades of blue). In my mind, it is an astounding visual that accounts for depression as well as how that relates to what is an unmistakable breakdown of money and especially monetary policy.
To aid in understanding this shift, we can take the whole history by parts. Picking up the story in mid-2008 when eurodollar futures’ concern had already proven correct (and Bill Dudley the fool), it was still unclear as to what that would actually come to mean. Over the course of the rest of 2008, it ultimately meant panic and massive global economic contraction. What followed, however, were expectations for full recovery; for the “emergency” monetary policies of ZIRP, QE, and some others to help ensure the historical outcome of symmetry.
It was the first instance of what has become familiar in economic accounts as well as financial; a downturn/reflation cycle, or what I have called depression cycles because of where this chart has already ended up. Viewing it by its discrete curves at these junctions, the evolution in expectations via the eurodollar futures market become perfectly clear.
The curve from December 28, 2009, several months already into official recovery, shows every expectation for a typical if very severe recession cycle, meaning an upside afterward to over time match the contraction. The front end of the curve (in red) had dropped near zero and extended sharply upward to rest at the far end very much like a normal curve would have. The difference, then, between the curve from May 2008 and the one in December 2009 is not just monetary policy, but rather its (first) big mistake! That mistake is perfectly demonstrated where and when the futures curve was at its flattest, most pessimistic – the day the FOMC announced QE and ZIRP.
Events up to that day had fulfilled the growing pessimism in this part of the money market where Bill Dudley (and the rest of the FOMC) would be forced to finally admit he was very, very wrong, and therefore to do whatever it took to finally get it right. The “reflation” idea is reflected in the curve dramatically steepening, displaying the expectations for money printing. After all, Ben Bernanke had said years before that the Fed possessed a printing press, and if ever confronted with the worst sets of scenarios they would use it.
The first reflation “cycle” shows that money markets assumed that under QE1 the Fed was using it, and that using it would, over time, work. Again, eurodollar futures are not money, they are only perceptions of it extrapolated into the future. That future was for the first time interrupted rudely toward the end of 2009 when rumors of debt problems in the Middle East and then across Southern Europe forced reconsideration – and ultimately more central bank responses. In the US, that took the form of a second QE, which eurodollar futures eventually priced as similar in effect to the first.
Already you can see that enthusiasm was literally hedged. It wasn’t enormous, but the difference was noticeable, which at that stage was important given what came next – the big break in 2011.
I constantly refer to the recurrence of really the same banking problems in 2011 because it is unusually clear in its effects on everything that followed. There were doubts before that time, but the world just hasn’t been the same after it. We see that in the “reflation” cycles that have followed.
The more immediate concerns about what happened in 2011 (which wasn’t ever really about Greece or PIIGS, but the actual money, or “money”, potential that was destroyed by financial entanglements with Greece and PIIGS) depressed the eurodollar curve all over again, so that by July 24, 2012, it was actually far worse than it had ever been during later 2008.
The inflection thereafter was, however, still very much like the one in December 2008. Just two days beyond that flattest point, on July 26, 2012, Mario Draghi would promise to “do whatever it takes” to preserve the euro. The Federal Reserve followed that September with a third QE, but one that was announced as different, being open-ended. From there, the eurodollar curve bounced higher (lower in price) in a second general “reflation” that was also similar to the first in that it viewed these “new” policies (and promises for new policies) as increasing the likelihood of success – where success in terms of eurodollar futures and money markets is normalcy.
But, as you can see above, “reflation” #2 stopped well short of the first. This was doubt again, only more pressing and significant. In many ways it was the same doubt that eurodollar futures had priced as far back as early 2007, that monetary policies might not be what everyone thought they were. Since eurodollar futures are monetary hedging, money market participants were hedging against a non-normal monetary future.
The end of “reflation” #2 came for eurodollar futures in very early September 2013, several months before it petered out in the UST market (and years ahead of stocks). It had been widely believed over that summer that the FOMC would vote at its September 2013 meeting to begin tapering QE3 (and 4). But in what would really set a precedent, they deferred until the end of that year.
For eurodollar futures, this was obviously significant as an indication and further confirmation of doubt; that FOMC confidence expressed all throughout 2013 and especially that summer was more bluster than reality. It set the stage for what would become the next depression cycle, the “rising dollar.”
The “rising dollar” is another one of these imprecise terms anchored in the conventional framework. It is and has been instead, for me anyway, a euphemism of larger forces, the true governing dynamics that include a general re-evaluation of money, monetary policy, and the actual role of central banks within them all. From the moment the futures market got wind of the Fed’s reluctance in September 2013, eurodollar futures were almost relentlessly bid, shriveling the curve to truly nightmare proportions.
Here, once more, we have to define our terms. Nightmare isn’t a technical term by any stretch, but when considering the context of money and economy it is natural to assume 2008 as that worst case. While that was certainly bad as an isolated circumstance, the real worst case is what followed it and what is now reflected in these eurodollar markets. Not a crash, but a world absent of its end.
It was in many ways the “Dudley doubts” on steroids, a complete reassessment of expectations about money during the very time the FOMC increasingly and emphatically claimed full recovery was right at hand. At its lowest point to date, the eurodollar futures curve suggested the bleakest future imaginable, one without normalcy at all. The Fed was previewing its parade route while money markets (and wider credit) were pricing a literal break with history.
In the months since early July, these markets have been once again teased by rumors, innuendo, and raw emotion about the next big “different” set of policies that will rescue the US and global economy where the last big sets did not. What you see in the eurodollar curve, even with this latest downward move (in prices) is, essentially, even greater disbelief. There is no comparison between “reflation” #2 and so far of “reflation” #3. Perhaps the idea will grow further as details about future policies become more than fuzzy speculation, but the difference (from the flattest point) is more about the front end than the back.
In other words, the FOMC has voted twice to raise the federal funds rate, but that isn’t the same as the “exit” officials had been talking about as recently as early this year. So far, despite those two “rate hikes”, the eurodollar curve isn’t even that much different than the curve on January 15, 2015, the day the Swiss National Bank was forced by the actual “dollar” to relent on the franc’s peg to the euro, unleashing the huge mess in forex that we still grapple with today.
In technical analysis of the stock market, the idea of higher highs and higher lows is important as confirming conviction in the direction. The same is true of the converse, of lower highs and lower lows. In many ways the eurodollar futures curve has traded in just that latter trend, with lower reflation “highs” and lower flattest “lows.”
Unlike stocks, the significance of this pattern here is deeply fundamental. The second half of 2016 has been a turbulent one for orthodox monetary economics. If you listen to what is being said (meaning the literature) it is being completely rewritten. Central banks have given up on QE not because they think it didn’t work, but because they have been forced to conclude that it couldn’t have ever worked. In other words, the FOMC at long last has embraced the eurodollar futures market.
Mechanically, the Fed now hopes for a best case scenario where they can “normalize” short-term interest rates to a high of perhaps 3%. That is nowhere near normal, of course, which is entirely the point, money as well as economy. It is a scenario that eurodollar futures have been moving toward for just about ten years, all the while dragging the FOMC kicking and screaming into this dark of depression. The whole idea of normal has been redefined to the eurodollar market’s view of it, not the FOMC’s.
Bill Dudley’s petulant reduction in 2007 was that the FOMC set money rates, not the eurodollar market. In reality, the eurodollar market proved monetary policy wasn’t actually money, and that it was reactive to what had already happened. As I put it earlier this month when they voted:
That leaves the second rate hike after all that has happened, and more so what didn’t (2016 was supposed to have been a remarkable economic improvement over 2015), projecting recovery that is in no way faithful to the word – nor, I am sure, what the mainstream is still claiming about it. The FOMC just added its two cents (in the format of idle, useless bank reserves, of course) that it agrees 15 months of contraction in IP is by these orthodox definitions as good as the Fed can make it, the new baseline trend for the US economy. Despite all the wreckage that remains after almost a decade of clearly broken promises, including how malaise has infected so far as to break out in social and political unrest, they are done.
Dudley was right if in one narrow sense: eurodollar futures don’t set the conditions for money. But they, at least over time, correctly sensed that the FOMC didn’t and doesn’t, either. There is the true disaster and nightmare in that distinction, ten years of it already.
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