Eurodollar University, Part 3: The Real Science Of Money

<< Read Eurodollar University, Part 2: Swaps First;

<< Read Part 1: Not Green Shoots, Shadow Prices

The repo rate above the federal funds rate is an assault on everything we’ve been taught. There is supposed to be a risk-driven hierarchy that governs financial markets, every single one of them. The global economy depends on it. If you are judged to be a higher risk, that’s who pays the higher interest rate. But repo is lower risk.

How can any participating financial institution sit there and let a secured interbank rate cost so much more than an unsecured? What does that mean?

That’s the big problem here. Trying to filter these real-world results through the prism of what you’ve been taught in Economics class, the shorthand that persists associated with being an investor (don’t fight the Fed!), or what passes for conventional economic wisdom renders these signals useless. It seems utterly confusing.

And that may be all you really need to know. Take a swap spread, for example. A negative one means what? In textbook terms, if the fixed rate paid on an IRS is less than the risk-free UST yield, this would appear to indicate the market is judging the US government as the riskier counterparty. Nonsense. Quite literally nonsense.

While on the surface it would suggest that the “market” in swap derivatives is pricing more risk of UST’s than swap counterparties, the only real inference about such compression is the nonsense itself. In other words, the nonsense nature of negative swap spreads is precisely the point – for them to be negative in the first place, let alone highly so (like the 30s again), is a pretty unambiguous signal of malfunction if not full distress. It is only great imbalance that can change the information content of a market price into meaninglessness; therefore, we can interpret that case as some great reduction in balance sheet capacity since it is dealer capacity that determines the nature of the spreads.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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