How Does Reflation Look From The Point of View of the One Market That Gets It
Eurodollar futures are derivative, cash-settled contracts linked to 3-month LIBOR (forget about SOFR and the official hatred of this offshore dollar rate regime). Though that rate acts independently especially at the worst times (thus, the hate), it is heavily influenced by the front-end monetary alternatives set by the Federal Reserve’s monetary policy (IOER, RRP). Because of this, LIBOR kind of seems like it should reflect whatever the Federal Reserve wants; and domestic central bankers love to make it sound like this is how it works (therefore, because it doesn’t work this way, they really, really want to get rid of it).
Institutions betting and hedging in this market aren’t positioning based on what Jay Powell and models at the Fed (and other money markets) thing the future might look like but instead what Jay Powell and the Fed will be forced to look at when that future gets closer. Central bankers are always, always behind.
In other words, the eurodollar futures market has, time and again, figured out what Federal Reserve monetary policy will look like long before Federal Reserve policymakers do. By the time officials understand what’s really going on, they’re following the market rather than the other way around.
This had been true, infamously, in the leadup to GFC1; the eurodollar futures curve had inverted as far back as December 2006, foretelling of truly serious problems that took Ben Bernanke’s group an entire year just to begin appreciating (while trying their best to ignore them).
And this was also the case just a few years ago; Powell declared early in 2018 how inflation and strong economic growth was going to lead to more aggressive rate hikes heading into 2019, when in the middle of 2018 the eurodollar curve inverted indicating – strongly – a growing likelihood he wouldn’t actually get much farther. As I wrote in July 2018, just after inversion first appeared:
Officials believe right now the economy is “very strong” and that demands the same “rate hike” trajectory. The futures curve is betting there is a good chance they are wrong about that and at some unknown point they’ll have to turn around and face their own mistakes yet again.
That “unknown point” turned out to be mere months ahead; by November 2018 it all started going very wrong (for reasons, mind you, that have never been explained at the official level; it wasn’t “trade wars” as even Economists knew there had to be more going on).
Heading into 2019, the Fed, like 2006-08, did indeed end up following the lead set by the eurodollar futures market. Literally:
As eurodollar futures can tell us very important things about dollar shortages and how or when they develop, these contracts can also tell us very important things about reflationary periods, too. Like the yield curve, we can examine the eurodollar curve for clues and relative comparisons in order to piece together a much more informed picture of the real situation (rather than the one imagined from DSGE models that take none of this into account).
For example, during Reflation #2 (2013-14), its appearance in the eurodollar curve was extremely short-lived; while the inflation nonsense had been kept alive in the yield curve if only to the end of 2013, in the eurodollar futures curve things had already been turning the wrong way months before (as the “EM currency crisis” further developed instead); this other curve had reached its apex as early as early September of that year.
By the start of 2014, when UST nominal yields began to contradict Bernanke and then Yellen, the recovery scenario each of them espoused had already been substantially discounted by this key market.
During Reflation #3 which took longer to develop, 2016-18, the same doubts came to be expressed in terms of the flattening the inverting curve – especially during 2018. The difference between Reflation #2 and Reflation #3 was only the Fed’s rate hikes; had Bernanke been raising short-term policy rates during 2013 the eurodollar futures curve would’ve certainly inverted, too, following September 2013’s peak.
Each of these reflationary periods, as told by eurodollar futures, came up way, way short of normalcy and the inflationary recovery scenario plastered all over the mainstream as a foregone conclusion (let alone the overheated inflationary storm many predicted).
When you look at the longer run outer contract years, which are less liquid but still interesting, you can see that, since 2014, the eurodollar futures market which once traded and hedged for possible normality in 3-month LIBOR if way out in the distant future has completely backtracked on the idea ever since that start of Euro$ #3; like inflation expectations in TIPS (these things very much related), the market said goodbye to any reasonable expectation for normal growth and inflation more than half a decade ago.
To put some raw numbers on it, when the December 2023 contract first debuted back in late December 2013, right at the peak of Reflation #3 in nominal UST’s, the market peered way out a decade ahead and figured that maybe 5% LIBOR could happen.
But, as only more global money problems ensued, the market has only moved further and further from that modest dream sequence; by the time the December 2024 contract was first written into existence a year later, in December 2014, the future had been severely downgraded yet again from which it has yet to be recovered.
Jay Powell only mumbles something about R* and some unsolvable inflation puzzle.
And this brings us to the current reflation episode, possibly #4 (though certainly not yet in terms of any economic data or conditions). This hasn’t stopped a second outbreak of inflation hysteria, of course, because no one really seems to have understood what happened with/to the first one in early 2018 – when all they needed was this eurodollar curve.
Like many other markets, eurodollar futures indicate that things are picking up from last year’s lows (like Treasuries, August 4); this is reflationary. But like Inflation Hysteria #1, here in Inflation Hysteria #2 many are basing their hysteria upon this (and other) market changing direction rather than appreciating the rest of the curve’s more indicative dimensions.
In other words, despite almost eight months of these reflationary tendencies, hearing about “money printing” and fiscal excesses the entire time, when we compare (apples to apples, normalizing curves by time dimensions rather than calendar months) reflationary curves you can better appreciate the utter lack of real reflation in the current one:
So much talk of the building inflationary monster when, in this market, the one that’s been (more) right about the world time and time again, it’s not even close. Any honest interpretation can only be modest.
Even the outer years, those 2023’s and 2024’s, supposedly well out of the reach of COVID, the market pricing in them is for the latter barely back to where it had been in early September 2019 (the “recession scare”), while the 2023’s haven’t even managed that much.
This December 2024 position is basically saying the first half of the decade of the 2020’s will somehow, on average, be materially worse than the 2010’s even if slightly better than the single and singly awful year 2020 had been where inflation and economic growth is concerned.
But that’s not the message you see all over the internet despite it being right here in the right market.
Thus, the eurodollar futures curve is incredibly low and flat, therefore like TIPS and inflation expectations in the longer terms, vehemently positioned for the all-too-sadly-likelihood that the only things which may have changed since COVID are more bad than good (see: deflationary labor market and lack of jobs).
And still no sign whatsoever of all that dollar-killing money printing. Like everything else, including the curve’s outer years, we’re turning Japanese.