Wednesday, May 27, 2009

The Debts of the Lenders: Eurodollar Futures Hold Key to Equity Markets

Fate is not w/o a sense of irony. Events move in cyclical patterns.

The answer to this spring's equity rally lies in last fall's TED spread. Or rather, 1 specific part of it, the Eurodollar futures. While a high TED spread was indicative of panic among market participants, a lower TED spread is indicative of confidence among traders. Remember Eurodollars are the ED component of TED w/the first part taken up by T or Treasuries (both are 3 month contracts).

Of course there are slight differences as the most obvious change is in FRONT MONTH eurodollar futures rather than three months out. The shift to front month contracts is indicative of bullish momentum among the "specs" or speculators that have moved away from hedging towards gambling - even as volume has declined. Moreover, global governments worldwide have decided that nothing is too big to fail and have turned on the monetary spigots - a decided change from last fall when they were more focused on damage control and ushering out a lame duck US President.

As I said in an earlier article,

institutional fund flows INTO bullish Eurodollar futures contracts are indicative of more risk taking activity. And the way to gain a peek into the fund flows is through the Commitment of Traders report that is released every Friday afternoon by the CFTC. I have been slowly gathering data from the COTs and noticed an extreme imbalance among bullish positions. The way to read these imbalances is to create a spreadsheet and then note negative correlations as "debits" in the system that traders are taking out as being bullish while positive correlations are "credits" returning back to the system where traders are being bearish. It's an imperfect and rather simplistic analogy but a rather fit one when you consider the futures markets are a "0 sum" game between traders. All outcomes are binary here. And the COTs captures it well.

All this spring, I had been looking in the wrong direction - charting the Vix, charting the S+P, charting the DJIA, charting bonds, charting yen - parts of it made sense but was often conflicting w/other data pts. In retrospect, the answer was simple. These were all parts of the whole.
It took a glance at the COTs data while doing my commodity crunching analysis for soybeans that I noticed the extreme Eurodollar position.

But this time, I believe that the COT holds the key. Moreso than other financial assets, Eurodollar positions are indicative of a greater pattern. It is like distinguishing the forest from the trees.

Conclusion: Chart the Eurodollar futures to find out where the rest of the market is headed.
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