As current sentiment becomes increasingly tuned into the narratives of policy-induced inflation/reflation, geopolitical posturing in a post-COVID world, and concerns around the long-term impacts of ZIRP/NIRP, there is one overarching puppet master of the markets that is not only potentially more influential than all the previous concerns (combined) but is one that is far less understood: The Eurodollar Market.
The Eurodollar Market, also called the Offshore Dollar Market, is something of a mystery in modern finance. It’s widely recognized that it exists, but its size, how it came to be, and the influence it has on today’s modern financial system are largely unknown. Even the most sophisticated investors can get tripped up if you ask them about it, and many dismiss it as some great unknown.
The US Dollar is a major driver of asset prices, but when trying to forecast its future performance, most financial market participants narrowly focus on the domestic US Dollar market, as opposed to the global US Dollar market. Analogously, this would be like trying to forecast the price of oil but only by taking into account US WTI production while disregarding worldwide Brent production.
Because of this, we’ve spent the last few months working out the full picture (within what’s possible to know) of the Eurodollar Market (an extension of the global supply/demand of dollars equation) to help us gain a broader understanding of the totality of the US Dollar market.
Let’s be clear, we’re not going to sit here and pretend we have all the answers. But, luckily, we know the guy who does. To that end, we asked Jeff Snider to help us in creating this deep-dive where we’ll explore:
If you don’t know who Jeff is, he’s the Head of Global Investment Research at Alhambra Investments and is widely considered a luminary in this space (and broadly speaking, knows more about the global monetary system than most of the people running it).
We’ve done our best to take what’s in Jeff’s head and break it down so that we can glean an understanding of the inner workings of this beast.
So, buckle up and enjoy!
“Most people realize there is a historical as well as functional significance to global reserve currencies. From global trade to gross financial investment across geographic and national boundaries, the modern, integrated economy doesn’t happen without an efficient, well-functioning dynamic global reserve system. Beyond the cursory, there’s very little depth to the public’s knowledge base. Few can describe the current monetary system’s basic factors let alone the finer details of how this reserve regime carries out these critical monetary roles. This is because the de facto global reserve currency isn’t the one you’ve been taught nor has it been for a very, very long time.” – Jeff Snider
In laymen’s terms, we care about the Eurodollar Market because it has a huge impact on the global reserve system (the US Dollar), which is a vital organ to a well-functioning and integrated economy.
The standard definition of a Eurodollar is any US Dollar that is on deposit in a bank outside of the United States (not just in Europe, that is simply the naming convention). Domestic US dollars in circulation can be measured in several different ways, but the broadest and most widely accepted is M2, which as of January of 2021 is ~$19 trillion. Eurodollars are, therefore, by the standard definition, all other US dollars in circulation not accounted for by M2.
Jeff broadens the definition, however, to include all dollars not under the watch of the domestic US monetary system (M2).
“Essentially, it’s a radical monetary evolution, away from the traditional format that was based on deposits of dollars, toward the more indescribable and ill-defined interbank market of these bookkeeper’s pen ledger balances moving back and forth.”
What Jeff is saying is that Eurodollars are made up of two distinct buckets:
It’s a difficult thing to believe, but no one really knows for sure where Eurodollars came from, but it’s generally understood that the market began sometime in the 1950s, and by the 1960s there was an unregulated monetary system blinking on the Feds radar. Consider this:
The first iteration of the Eurodollar Market materialized in the form of a Bankers Acceptance Note (Note), which was essentially a Certificate of Deposit, denominated in USDs, which allowed two foreign nations to transact with each other, as efficiently as possible.
The mystery, however, is that there is no definitive understanding of the evolution from this exchange system, to where we are today, with dollars on deposit outside of the US.
Remember, Notes are certificates that you effectively “buy” from the US and use as currency or collateral to trade, without having USDs leave the US.
Eurodollars are, instead, USD reserves in foreign countries that effectively remove the need to “buy” certificates from the US as one could simply use the USDs available for exchange of goods.
What this meant was there no longer needed to be exchanges of cash upfront for these things to work (like in our Japan and Sweden example). This was a more elegant and efficient (albeit unintended) solution to a cumbersome problem (foreign countries transacting in non-domestic currencies).
Like the Note, the EDM first and foremost filled the need for common liquidity settlement mechanisms in global trade, but in a more efficient way.
A pieced together theory of this evolution through a variety of sources is as follows (thank you for doing all the leg work on this Jeff!):
It’s worth repeating, that there really is no definitive knowledge about where these Eurodollars come from. Interestingly, in the FOMC minutes from the 1960s, the mention of ‘Eurodollars’ evolved slowly, then all at once.
At the time, a high-ranking official of a global bank postulated that the source of Eurodollars was “partly, U.S. balance-of-payments deficits, partly dollar reserves of non-U.S. central banks, partly the proceeds from the sale of Eurodollar bonds”.
Milton Friedman essentially said this explanation was ‘complete nonsense’ and offered the explanation that “their major source is a bookkeeper’s pen.”
Back then, the gold standard was still in effect (not lifted until 1971), and so there was an understanding that under a gold standard, you can’t inflate the value of dollars away by printing because they had to be backed by gold. This held true, but only in domestic terms, which was where the US had control over the USDs.
With the emergence of the EDM, understanding the money supply from a global perspective became impossible as the USD to Gold ratio became completely distorted (as large volumes of USDs were being printed outside of the US without The Fed’s approval). Implied here is that even before the de-pegging from gold and today’s QE-infinity, there were new USDs being created, and destroyed, basically out of thin air, in the offshore market.
Bretton Woods was created with an inherent weakness in it where central banks could circumvent all the protocols that were supposed to keep the USD and Sterling in a specific value range.
The EDM in the 1960s can be characterized by foreign central banks actively using specially swapped transactions to do just that (keep the USD and Sterling in a specific value range).
In other words, they were undermining the Bretton Woods system through the use of Eurodollars as a way to increase or decrease monetary supply beyond the limits of the gold peg because, realistically, these central bankers never wanted to be constrained by gold.
This means that even though there was supposed to be a gold backing of the USD and Sterling, by the middle of 1950, this was increasingly not the case.
The 1960s then saw the rise of Triffin’s Paradox, which explains a conflict of economic interests that arise between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies2. This helped explain this ‘thing’ taking place outside the US monetary system that no one really knew about. There was obviously some level of concern over ‘it’, but The Fed wasn’t even sure if it was a violation of the Bretton Woods agreement or not, because they didn’t even know what ‘it’ was.
Considering all that was going on, Milton Friedman was asked to investigate and come up with a theory for what exactly was happening. He found that what was happening was a money multiplier system in parallel to the domestic system.
A basic example:
This was what Friedman meant, that USD owners transferred money abroad to get better returns on their deposit, thus increasing the amount of USDs in foreign countries.
Building off this example, the system continues to grow. If instead of the London bank lending to a London company to trade with a US company, if that London company trades with a Russian company, and then that Russian company trades with a Chinese company, this process will continue to expand the EDM. The only restraint on its growth are reserve requirements:
This example is then taken one step further, driven by interest rate differentials between the US and other countries.
At the time, US banks were regulated as to the amount of interest they could pay out in deposits. Those constraints did not exist in other financial centers around the world, leading investors holding USDs in the US to send their money abroad to get better rates.
To accelerate central banks circumventing the system around that same time, US banks began setting up foreign subsidiaries as they were trying to limit the amount of money that left their balance sheets to go international.
All of this goes back to Friedman’s quote about where Eurodollars come from, “their major source is a bookkeeper’s pen.”
We now need to broaden the definition one step further, because we have yet to discuss how the banking system saw a means to exploit this burgeoning market. I know I know, it seems strange that the banking industry would lever up an opaque, unregulated market to make a few bucks, but we’re telling you the truth!
Simply put, by leveraging their balance sheet, a bank can create additional money that is not captured in traditional statistics (M1, M2, etc.).
The primary methodology is the wholesale Repurchase Agreement Market (The Repo Market).
The repo market is basically an overnight exchange of cash for collateral, conducted between banks and corporations. It’s a market where short-term cash can be lent in exchange for a security (known as repo collateral) that bears interest (the repo rate). Assuming the cash is returned with interest, the collateral security is returned to the cash borrower. If the cash is not returned (highly unlikely), then the cash lender takes custody of the collateral security and is able to sell it in the open market. It’s essentially a short-term collateralized interbank loan, and for both sides is ‘relatively’ low risk.
In the 1970s, as money supply targets and all the money definitions were breaking down, many economists started to notice that something was wrong and began to investigate what was going on in the monetary system.
In a FOMC discussion from 1974, an open market manager brought up the idea that they needed to scrap M1 as a money supply indicator because it was no longer valid. He stated that they should start focusing on M2, but even M2 was going to become obsolete in the future and that they should develop something like M3. The reason for this was the evolution in money where the traditional formats that they used to define before were no longer valid.
A prominent economist, Stephen Goldfeld, wrote a famous paper titled “The Case of the Missing Money”. It emphasized the idea that the monetary system was evolving in ways that economists at the time (even today) didn’t fully grasp or understand.
What he describes in the paper is the idea that money demand forecasts were off, and off by a significant amount. He found that they would forecast money demand for M1 or one of the other aggregates, and they would always come up short in the actual money demand. Something else was satisfying economic demand for money. Even though the economists and policy makers at the time didn’t know what was driving the differential between forecasted and real money demand, it was obvious that something else was.
What was clear, was that there seemed to be a system in place that, without the knowledge and supervision of the monetary authority, was providing USD liquidity to where there was demand for it.
They would continue to investigate, and by the later 1970s they had a couple of different candidates. Chief among them was the Repo market.
This finding was a major revolution in understanding the dynamics of money supply demand, where the entire system was now needing to be defined in ways that were outside of the traditional mechanics of simple CDs, (and everything else that’s in M1).
At the time (1970s), there was a reluctance to add repos to monetary definitions, because it didn’t seem to fit the idea of money. It’s not that officials didn’t know there was this repo market out there, because in some form repo agreements go back to the earliest days of The Fed. And in foreign capacities even farther than that.
From the outside, even officially, the idea of repo as money might not have seemed like a legitimate explanation for the missing money. But the way the banks were using these agreements, as The Fed found out in the spring of 1979, was that corporations were depositing assets into other accounts where they would use a repo transaction that would be settled the next day. And then they would use those accounts to undertake monetary transactions3.
In other words, they would write checks against the repo account, even though the funds were segregated outside of the traditional definition of a deposit (therefore outside of the M1 definition), and then they would be settled against that account. Here, repo transactions began to create new money (the checks they wrote against those repo accounts).
Even though officially, The Fed works on various ways to incorporate things like repo agreements and money market funds into the official statistics, they often did not have success in doing so. A key reason why is that repo transactions are mostly one-to-one, and therefore they are known only to those participating in them. They aren’t centrally cleared (even today), and even when any transactions are (such as tri-party repo) there’s an impenetrable tangle (especially on the collateral side) which makes any estimates or tracking nearly impossible.
This money supply that doesn’t conform to the traditional definitions was taking place in the shadows, which are essentially the liability side of banks.
Michael Lewis’s book, Liar’s Poker, chronicles Solomon Brothers (SB) and the takeover/rescue by Warren Buffet. At the time, SB was constantly overbidding, sometimes to the tune of 100%, for US Treasury’s at auctions. The Treasury eventually told them to stop it, that they weren’t meant to take over the entire auction, but SB persisted, to the point where the Treasury created the Mozer Rule (Mozer was the SB trader who was overbidding) where a single bank could no longer bid for more than 35% of the total auction. SB continued to overbid, which eventually caused The Fed to launch an investigation because they couldn’t figure out why SB would consistently be overbidding.
What they found, was that the entire banking system was overbidding for USTs at auctions.
So why was the entire banking system overbidding for paper that seemingly made up a small percentage of their overall profits? Because of the rise of the repo markets.
Essentially, the banks were overbidding for USTs to use as collateral, because the repo market was so lucrative, but they needed collateral to run the operation. USTs are the most pristine collateral (US Gov’t never defaults (yet)), which is why banks were trying to get as much of it as they could, and by the 1990s it had become an enormously important part of the funding dynamic. This was also true in the MBS market, though at the time it was a much smaller component as MBS was still in its infancy.
So how does this work?
By the early 1990s there was this sense that, outside of the US, there is immense growth in this wholesale format being added to the Eurodollar format which was already very large. Throughout the 1980s it had expanded to such a high degree that people were shocked in the early 1990s by what was actually going on outside the US.
Alan Greenspan’s famous 1996 speech, ‘Irrational Exuberance’, was actually given because of the topic of missing money. What he said was, in effect, the correlations with money demand, correlations even with money supply, had long ago gone way off the rails, and had got to the point where The Fed couldn’t even predict either side of the monetary equation.
He said in his speech that he expected the money would “come home” so to speak, but in later dialog, speeches, and discussions (one such is the June 2000 FOMC) he admitted that it never did.
Therefore, it was a difficult path for a central banker to try to handle monetary policy under conditions where they couldn’t even define money. He wasn’t explicit in stating that it had happened this way, that monetary policy had evolved into a discretionary format because they couldn’t define money, but that is what he said in various hints and reading between the lines of many of his speeches.
More mystery during this era was the shift by The Fed from targeting money supply to today’s emphasis of targeting the fed funds rate. When this actually took place is unknown.
From the abstract of the paper, “When Did the FOMC Begin Targeting the Federal Funds Rate? What the Verbatim Transcripts Tell Us”
The Fed never specifically came out and said, “this is the date we stopped targeting money supply or money demand actually and started targeting the fed funds rate.” But in a regime where you can’t define money, either supply or demand for it, what do you do as a central banker?
What they came up with was based on Milton Friedman’s work and principles, where inflation is certainly a monetary phenomenon. So, what they decided, in the 1990s, was that monetary policy would be effective (they assumed) as long as inflation stayed low or within their target range.
If inflation was well-behaved, they would assume that it was because monetary policy was effective. And the way monetary policy was determined was the discretionary approach to moving the fed funds rate either higher or lower based on, essentially, a seat-of-the-pants type of assessment of the economy and the markets.
This is a more complete reality of how the 1990s unfolded, with The Fed flying by the seat of their pants, and because things seemed to be good and everything well-behaved (especially inflation), everybody assumed that the correlation was between the economy (especially inflation) and monetary policy. In other words, Greenspan must have been a maestro for doing whatever it is he did.
Only in hindsight do we see that he simply may have been an accidental genius.
To be clear, Greenspan never actually came out and said exactly what they were doing. All he did was raise and lower the fed funds rate, but nobody could really determine, nor did he specify, exactly how they did that.
What caused the Fed to raise the rate 25 basis points one day and then the next meeting maybe lower it?
What we know today is that it was a completely discretionary policy that had absolutely nothing to do with money whatsoever.
“You’re a kite dancing in a hurricane, Mr. Bond” – Mr. White to 007, Spectre
Though Bond is way too cool to be characterized as a Fed Chairman, it’s an apt quote to end this story. What we seem to be led to believe is that the global monetary system is more representative of a Hurricane, formed not by man but by nature, and those tasked with controlling the Hurricane are more like a plastic kite, simply dancing around with little to no say on the course the weather system chooses to follow.
Because after writing this I feel like Dom Cobb, three dreams deep and not sure if the dreidel is going to fall or not, we’re going to take a break from the Eurodollar Market for now, but our future US Dollar views will continually refer to this foundational piece. We’re going to continue working with Jeff and adding Brent Johnson of Santiago Capital to the mix to get their views on how the EDM influences their thinking when it comes to future Dollar movement.
Down the Rabbit Hole :
Down the Rabbit Hole: Triffin’s Paradox is the conflict of economic interests that arise between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies.