This QE carry trade nightmare became reality last week, and the Eurodollar pit was ground zero. As carry trade asset prices come under pressure due to rising US real interest rates, investors are forced to sell Eurodollars to hedge higher financing costs and negative gamma exposure. The magnitude of the selling implies that there is a lot of money exposed, but it’s not clear what still needs to unwind.
Last week, there were rumors of bond dealers who were both liquidating MBS inventory and ceasing to bid on these securities until quarter end. There were also accounts of liquidity drying up in the Treasury market. When dealers cease to bid on the assets that collateralize the loans for carry trades, the system is frozen. This is serious.
If you believe the accounts in the media, you would think the Fed believes the move in the front end of the yield curve, including the Eurodollar strip, is a misinterpretation of Fed tightening. The Eurodollar market not only has an interest rate component but also a credit component, and one interpretation of the blow out in the strip is a spike in banking system credit risk.
…Make no mistake about it: Bernanke is blowing up the QE trade he engineered. The question for markets at this juncture is not what assets are exposed to this trade but rather how much capital is exposed and who will take the other side of the unwind. The move in the most liquid part of the rates curve suggests that the position is very deep; the reluctance of dealers to bid on financing collateral suggests the bid is very shallow. Finding a level where that bid/ask comes together is likely to be a very disruptive process, and if history is any guide, the “collateral” damage will be felt around the world.