Here at the mid-point of 2022, investors are assessing the terrible first half of the year and wondering what the second half will bring. As we peer ahead right now, the stormclouds outnumber the sunbeams, and one of the areas looking particularly stormy is the eurodollar…
“Eurodollars” are dollars that circulate outside of the US. It’s unknown how large this foreign market for dollars actually is, but estimates have it pegged at over $13 trillion. Many attribute the growth of this gargantuan market to the petrodollar system, by which Arabian Gulf oil producing countries (most notably Saudi Arabia) denominate oil transactions in USD.
The petrodollar system, which has gone through ebbs and flows, began in 1945. Since that time, many countries have adopted dollar currency pegs and often denominate large sovereign loans in USD as well. The eurodollar futures market has grown into a monster and according to Jeff Snider of Atlas Financial, is the most important signal to watch.
In mid June, the Dec 22 and Mar 23 eurodollar futures contracts inverted. Essentially, this means the market is anticipating the Federal Reserve to cut rates during Q1 2023.
Given there is not a single FOMC member anticipating a rate cut this early, what’s going on here?
According to Snider, “Our baseline best case here is a shallow recession, and I think the markets are starting to contemplate something more serious than even that.” In his view, the eurodollar market is flashing red, indicating that something will occur between now and end-of-year that will force Fed officials to reverse policy.
We can speculate on what will cause such a pivot: recession, market crash, political pressure, etc. Regardless, the eurodollar curve foresees a crisis that the FOMC does not.
Taking a deeper look into Jeff’s world. You may have heard of “yield curve inversion” in financial headlines recently, most frequently referring to the 2-year Treasury yield exceeding the yield of the 10-year. Snider emphasizes the importance of analyzing multiple yield curves. Depicted below we see the spreads between the 2 vs. 10, 5 vs. 10, 7 vs. 10, and even the 3-month vs. 2-year Treasuries:
All curves except for the final one have inverted in the last couple of days. Perhaps most significantly, the 1-year Treasury yield has exceeded the 10-year by levels not seen since 2007!
To sum all of this up in layman’s terms, Snider interprets the yield curve tea leaves to be pricing in a severe deflationary market event, like the Great Financial Crisis or perhaps worse. Despite the buy-the-dip mentality being pushed on CNBC by personalities like Jim Cramer, the eurodollar and Treasury curves are essentially telling us that all major market indices are likely to head lower.
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