We are led to believe the Federal Reserve and other central banks are hear to save the day. In reality, their actions are only causing a massive amount of global pain.
This is being clear as day in the Eurodollar System. When we look at the true money supply, we see how the massive interest rate hikes are causing enormous problems.
In the end, we are seeing a contraction of epic proportions. This is why the global inflation that people were going crazy over with rising CPIs around the world was nonsense. It was transitory all along since the price increases were unsustainable.
This is why an understanding of this market is crucial.
Image: Pavel's Snapshots
Collateral Is King
In the Eurodollar System, nothing matters as much as collateral. High quality collateral is what is regularly sought. This is what allows the system to expand and, in turn, the global economy.
When this is scarce, contraction takes place. Sadly, since the Great Financial Crisis, deflation was par for the course.
Under this system, credit worthiness means nothing. The most important factor is liquidity, i.e. the ability to turn the collateral into "cash" if the loan enters default. Hence, we are looking at depth and liquidity.
For this reason, U.S. Treasuries are king.
Collateral Contraction
To understand what took place, it is important to go back a couple decades. At that time, we were told that mortgage backed securities (MBS) were the same as Treasuries. This was from Wall Street rating agencies.
It was what caused the massive run up in real estate during the early 2000s. The resulting insanity was liar loans and people getting multiple homes simply on their signature. Banks were lending like crazy because financial institutions on Wall Street were buying the paper like there was no tomorrow.
The loans were being broken up, repackages, and sold into the market. Since they were rated the same as US Treasuries, few thought twice about the risk.
As we know, the MBS weren't on par with Treasuries. Instead, people were buying junk as evidenced by the global crisis that ensued.
The implosion resulted in this being removed from the market.
Negative Interest Rates
Post-2008, we had sovereign debt to fuel the Eurodollar System.
Here is where we see the actions of central banks affect a system without any idea of what they were doing.
Around 2013, Lawrence Summers put forth the idea of how negative interest rates were a good idea. What ensued was many central banks around the world adopting this policy. Unfortunately, this nuked their bond markets.
No longer was this high quality collateral. The markets dried up as demand plummeted. After all, who wants to pay to hold bonds?
This removed another major piece of the collateral puzzle. Basically, since that time, U.S. Treasuries were the only game in town. It is what is needed to step into the arena and get a strong interest rate (along with a decent overcollateralization).
Balance Sheet Constraint
Recent central bank action pushed interest rates up at a pace never seen before. The move from historic lows have caused major issues.
At the core is the value of bonds. When interest rates go up, previously issued bonds drop in price. There is an inverse relationship between the two.
Over the past 15 months, we saw an inverted yield curve (18 months in LIBOR/SOFR futures) that caused demand at the long end of the curve to dry up. Now we are taking those assets off the collateral table.
When a firm drops $10 million into bonds and they drop in value by 30%, the ability to use as collateral drops by at least that amount.
This means that assets which were available for collateral on loans are worth less than they were before. Hence, the entire balance sheet is constrained, causing contraction. Multiply this across the $125+ trillion bond market and we can see how this is a major concern.
Again, we have to keep in mind that this is the source of funding of global trade. When balance sheets are constrained, loans decline meaning commerce is affected. This is exactly what is happening.
Dollar Shortage
There is another problem that most do not realize.
We are suffering from a shortage in US dollars. This comes as a surprise since many believe that the Fed was "printing" trillions of dollars the last few years. That actually is not the case. The Fed doesn't print dollars other than banknotes.
Where the shortage is coming from is in the Eurodollar System. Balance sheet constraint means that banks cannot get a hold of the dollars required. We are dealing with ledger based money with is tied directly to assets.
Almost half the loans in the world are denominated in USD. This means that corporations have to gain access to the currency (via ledgers) to make the payments. As the contraction continues, it makes it more difficult to avoid default.
This is what the world is facing.
It is also why the biggest problem confronting the global financial system is finding high quality collateral. For now, US Treasuries are the only game in town and many of them are not liquid. Hence, even there, we are only dealing with the short-term securities.
This is how important the Eurodollar System is.
