EuroDollar Futures Selling Off

A: Taking a step back from Manhattan real estate for a moment, I want to point something out. Since yesterday, Eurodollar futures have sold off noticeably. I want to explain why I think this will be significant IF the sell-off continues! Right now its too early and more of an eye-opener waiting to see if it continues.

In general, I have noticed a disconnect lately between credit indicators and equity indexes. Since early/mid 2007, credit indicators have been a very accurate LEADING INDICATOR of where equity prices were heading over the short term. In other words, credit markets were driving stock movements; first credit markets would deteriorate, and soon after stocks would have a new wave down as discussed in "Stocks Lagging Credit Markets" discussion.

But recently, credit indicators have come in (a good sign) as TED spread is down below 1, corporate bond spreads came in, LIBOR has come in, commercial paper market was improving, yet stocks did not rally as much as one would expect for these types of improvements.

Now, Eurodollar futures are selling off since yesterday. Look at the very recent drop, where I enhanced the section from the past 5 days or so:

*To get chart on Bloomberg Terminal type in 'EDH9' + COMMODITY + GO

This is important in the context with which it is occurring. First, let me get a textbook definition of Eurodollar futures:

A Eurodollar future is a future on a three-month Eurodollar deposit of one million US dollars.

CME Eurodollar futures prices are determined by the market’s forecast for the delivery date of the 3-month USD LIBOR interest rate. The futures prices are derived by subtracting that implied annualized interest rate from 100.00. For instance, an anticipated annualized interest rate of 5.00 percent will translate to a futures price of 95.00. On the expiry day of a contract, the contract is valued using the current fixing of 3-month LIBOR.

Eurodollar contracts are extremely popular due to their ability to accurately hedge LIBOR swaps and other market instruments such as mortgage market debt. The correlation with mortgage market debt is extremely high, higher than the CBOTs Treasury Futures contracts.

As Eurodollar futures fall, yields rise which means we likely will see the 3-MTH LIBOR rate rise too. When we see an equity selloff, usually we would expect rates to fall, to compensate for the expected slowdown ahead. But the fed has no more room to cut rates!! With Eurodollar futures selling off noticeably yesterday, and other credit indicators having less of an effect on equity movements lately, I wonder if things might be changing a bit in terms of WHAT FORCE moves the stars (equity prices). Lets never forget that the stock markets are probably the most widely used gauge as to the health of the economy.

Some thoughts:

1) If rates are at ZERO and stocks sell-off but eurodollar futures see another sharp sell-off at the same time, how much is 'credit risk' really deteriorating? How high may borrowing costs rise just as a new round of fear takes over equity markets?

2) Will this lead to a new round of forced selling to raise cash to compensate for coming rise of borrowing costs?

3) Does the 'credit risk' include worry over the US government's ability to repay its debts? I do NOT think the US gov't will default, BUT, that does not change the fact that market players won't QUESTION the US gov't's ability to repay its debts. That is why we have CDS trades on treasuries. Last time I checked, CDS on 10-YR US TREASURY was at a record of about 68 Bps. Anyone got the last quote?

So, will we see a surge in the 'other' credit indicators in the near future? TED? LIBOR? Will Eurodollar futures become the 'GO TO' indicator for the next couple of months? Time will tell, but my eyes are shifting to whether this may be signaling a new wave of fear based trading. If it does, it gets moved up my list of things to keep my eyes on.

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