Don’t look now, but US dollars are tightening again. The dollar calm that swept over markets since September 4 appears to have reached a nadir on October 23. Eurodollar markets in late October only moved very slightly, but enough to keep futures from rolling with the calendar, and thus indicating that risk positions and balance sheet expansion might be changing. Since the end of October into the first few trading days in November there has been a much more noticeable change toward a tightening bias.
Right now it doesn’t look like enough to cause any problems, but since funding and credit markets never fully retraced the May/June selloff, the impact has begun to ripple through all the various interconnected markets.
Since October 23, the UST 10-year has moved 15bp, and swap spreads have moved slightly lower (without much perturbation).
Inflation breakevens, a measure of credit market expectations for inflation, have come down further. The 5-year breakeven now sits near the June 24 low, meaning that credit markets are acting very much like they did during the May/June bond rout – rising yields and lower inflation expectations. That is pretty much the opposite of what you would expect if QE were having the intended effect.
Finally, you do have to wonder about the World Bank’s warning from September. The action in the Brazilian real and Indian rupee since September 4 was not a vindication of those countries’ respective central bank actions, though it has largely been framed as such. The easing conditions in eurodollar markets bought some time for India and Brazil, as the World Bank suggested. Since October 23, however, the potential inflection toward more dollar tightening might reignite the EM crisis.
So far, Brazil has caught the worst of it as the real has devalued close to 6% over the period. It has been the most sustained selling of reals since August. If the dollar tightening continues, the Banco do Brasil has to be very concerned about all those banks it enticed into shorting the dollar on its behalf. There is some very bad potential there, as dollar tightening coupled with banks caught the “wrong” way can get out of control, certainly overwhelming the dubious swaps program.
We don’t know if this new trend in the dollar funding markets is, in fact, a trend, but it is clearly setting up as such. Without “guidance” from the FOMC, markets are taking a bearish position on risk, including as it relates to US economic performance and monetary efficacy. The non-taper calm may have run its course, and reality may be rudely intruding again.
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