The Potential for a Violent Move in Markets

Jonathan Ogden emails:

The move higher in Eurodollars is relentless with the Sep Contract hitting an all time high today of 99.655 implying that 3-mo Libor will be .345 at September expiration(2nd london business day prior to the 3rd wednesday). 3-mo Libor was set at .3455 this morning pretty much inline with what the ED contract is saying it will be about a month from now. Here are the implied 3-mo Libor rates going forward:

Dec 2010 .395

Mar 2011 .455

Jun 2011 .555

Sep 2011 .695

Sep 2012 1.43

Sep 2013 2.18

Sep 2014 2.865

Sep 2015 3.435


The entire ED curve has been moving higher since the "end" of the euro banking crisis, indicating the market is getting more and more committed to the idea of lower rates for a longer time. Back in April the market was pricing in a 3-mo Libor rate of almost 4.50 for Sep-2013 and now its down to almost 2.00 .

One thing that makes me very worried is how market participants seem to be pushing their bets that rates will stay low for an extended, extended, extended period. There are a number of profitable strategies being employed to do this. It looks like easy money to many. As more people put on these trades the risk/reward profiles shift (less reward, more risk) and the trades become increasingly crowded by weak hands. If short rates were ever to spike or be pushed higher the unwind of these massive trades will be devastating. Even if policy makers begin to hint at higher rates the markets could react violently, creating a whole new series of financial shocks.

Jon nails it. The very low rates indicate most players are trading based on the belief that rates will be very low for a long period of time. Even if such traders are correct in their long term view, a strong technical correction to such one-sided trading is very likely. However, since the fundamentals of soaring debt loads point to much higher rates at some point, the reaction against the downtrend is likely to be extremely intense. I would not be surprised to see 100 basis point moves to the upside in rates. When the real estate bubble was expanding, I warned that those in the real estate market would never get out alive. The problem is more severe for those who are trading based on low rates. They will get bludgeoned to death.