Financial Markets Already Expect the Next Financial Crisis

Financial Markets Already Expect the Next Financial Crisis

Last week, we looked into the pickle that central bankers find themselves in:

Do you think central banks will tighten monetary policy and risk a sovereign debt crisis in order to get inflation under control? Or do you think that central banks will ignore inflation and keep printing money in order to fund their governments?

Well, it turns out that financial markets are now pricing in the former. At least, an obscure part of financial markets is…

And if traders there are correct, this suggests we’re in for another 2008-style financial crisis as interest rate hikes try to fight off inflation. Or, at least, another 2018 stumble.

But what is this signal I’m talking about? And where did it go off?

First of all, do you really want to know? Because the explanation isn’t simple. And it’s not a very nice conclusion we’re going to reach either…

To begin, we’ve got to go right back to the hidden financial system that operates around the world, except in the US…

The world of eurodollars is a tough one to grasp. And it has a fascinating history. You’ll have to forgive an oversimplification for today, but here’s the short version…

The US dollar is the global reserve currency. It is used and useable everywhere. Commodities, for example, are priced in US dollars, even if they are bought and sold outside of the US, and traded on foreign exchanges.

This creates an odd situation for banks from outside of the US, who are operating outside the US, but who are dealing in US dollars. Who are they regulated by? Which central bank monitors and supervises them?

It turns out that there’s a bit of a loophole for US dollar deals done outside the US. And, as you can imagine, banks love regulatory loopholes.

Even though it has nothing to do with euros, nor necessarily Europe these days, it is known as the eurodollar market because that’s how it got started, back when the major financial centres were to be found in just the US and Europe.

The eurodollar world is a sort of rogue US dollar borrowing and lending market not subject to supervision by the US authorities. And it is big. Very, very big.

But that’s not the point for today. The point is that the eurodollar interest rate futures curve recently inverted. This is a signal that a financial crisis of some sort is likely, if not expected, by traders there.

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Before I explain, a quick reminder why you should care.

The eurodollar futures inversion of 2018 signalled the worst period for stockmarkets since 2008, for example. So you might want to pay attention this time around too.

Unfortunately, the theory is also a little tough to understand, even if the narrative is simple.

Just as government bonds have a yield curve, so too does the eurodollar market, in a way. But what’s a yield curve?

Normally, a government can borrow money for short periods of time at a lower interest rate than for a long period of time. Thus, the longer the maturity of the debt, the higher the rate.

If you plot this relationship on a chart, you get an upward sloping curve. The longer the government wants to borrow money for, the higher the interest it must pay.

This is true for a long list of reasons but think of it as a temporal version of Murphy’s law. The longer the time period, the more chance there is of something going wrong, and so the higher the interest rate demanded by lenders for lending that long.

But when the yield curve inverts, meaning that longer-term borrowing is cheaper than short, this is a sign that Murphy has been spotted on the horizon and is coming our way.

More specifically, a yield curve inversion signals that financial markets expect interest rate cuts, or a financial crisis, to occur in the future. Not that there’s much difference…

In plain English: The eurodollar market is expecting interest rate cuts in the next few years, after a few hikes that fight off inflation. This implies a risk of a crisis, as it did in 2018. One triggered by tighter monetary policy, as in 2008.

But why focus on the eurodollar futures curve and not the commonly known government bond yield curve?

The answer is that central bankers have a rather large influence on governments’ bond yields these days thanks to QE. They’re not a free market anymore. The yield curve is manipulated by central bank buying. And so its ability to signal trouble is weakened.

Eurodollars are outside of the jurisdiction, you might say, of central banks’ influence. This is only true to an extent, but the point remains.

To be clear, yield curves speak in terms of probabilities, not certainties. But the point is that traders are deeply worried about the prospect that ‘central banks will tighten monetary policy and risk a sovereign debt crisis in order to get inflation under control’, as I put it last week.

Are you ready?

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

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