Primer: The Eurodollar Market
The Eurodollar Market is one of the most influential and least understood drivers of financial markets.
Key Takeaways
- When trying to forecast US Dollar movements, market participants tend to narrowly focus on the domestic US Dollar market, as opposed to the global US Dollar market (domestic + Eurodollar market), which also includes all US Dollars in circulation outside of the US.
- The Eurodollar Market is one of the most influential and least understood drivers of financial markets. It is one of the fundamental reasons why monetary policy has historically been ineffective and illustrates the limitations of Central Banks in their ability to quantify US Dollar supply and demand.
- We explore the origins and developments of the Eurodollar market and conclude that without efforts to fully understand it, we’re unlikely to successfully control US Dollar inflation.
As current sentiment becomes increasingly tuned into the narratives of policy-induced inflation/reflation, geopolitical posturing in a post-COVID world, and concerns around the long-term impacts of ZIRP/NIRP, there is one overarching puppet master of the markets that is not only potentially more influential than all the previous concerns (combined) but is one that is far less understood: The Eurodollar Market.
The Eurodollar Market, also called the Offshore Dollar Market, is something of a mystery in modern finance. It’s widely recognized that it exists, but its size, how it came to be, and the influence it has on today’s modern financial system are largely unknown. Even the most sophisticated investors can get tripped up if you ask them about it, and many dismiss it as some great unknown.
The US Dollar is a major driver of asset prices, but when trying to forecast its future performance, most financial market participants narrowly focus on the domestic US Dollar market, as opposed to the global US Dollar market. Analogously, this would be like trying to forecast the price of oil but only by taking into account US WTI production while disregarding worldwide Brent production.
Because of this, we’ve spent the last few months working out the full picture (within what’s possible to know) of the Eurodollar Market (an extension of the global supply/demand of dollars equation) to help us gain a broader understanding of the totality of the US Dollar market.
Let’s be clear, we’re not going to sit here and pretend we have all the answers. But, luckily, we know the guy who does. To that end, we asked Jeff Snider to help us in creating this deep-dive where we’ll explore:
- What exactly is the Eurodollar Market.
- How it came to be.
- How it operates and who or what regulates it.
- How it affects the global monetary system.
If you don’t know who Jeff is, he’s the Head of Global Investment Research at Alhambra Investments and is widely considered a luminary in this space (and broadly speaking, knows more about the global monetary system than most of the people running it).
We’ve done our best to take what’s in Jeff’s head and break it down so that we can glean an understanding of the inner workings of this beast.
So, buckle up and enjoy!
Preface
“Most people realize there is a historical as well as functional significance to global reserve currencies. From global trade to gross financial investment across geographic and national boundaries, the modern, integrated economy doesn’t happen without an efficient, well-functioning dynamic global reserve system. Beyond the cursory, there’s very little depth to the public’s knowledge base. Few can describe the current monetary system’s basic factors let alone the finer details of how this reserve regime carries out these critical monetary roles. This is because the de facto global reserve currency isn’t the one you’ve been taught nor has it been for a very, very long time.” – Jeff Snider
In laymen’s terms, we care about the Eurodollar Market because it has a huge impact on the global reserve system (the US Dollar), which is a vital organ to a well-functioning and integrated economy.
What is the Eurodollar Market?
The standard definition of a Eurodollar is any US Dollar that is on deposit in a bank outside of the United States (not just in Europe, that is simply the naming convention). Domestic US dollars in circulation can be measured in several different ways, but the broadest and most widely accepted is M2, which as of January of 2021 is ~$19 trillion. Eurodollars are, therefore, by the standard definition, all other US dollars in circulation not accounted for by M2.
Jeff broadens the definition, however, to include all dollars not under the watch of the domestic US monetary system (M2).
“Essentially, it’s a radical monetary evolution, away from the traditional format that was based on deposits of dollars, toward the more indescribable and ill-defined interbank market of these bookkeeper’s pen ledger balances moving back and forth.”
What Jeff is saying is that Eurodollars are made up of two distinct buckets:
- The first is the Eurodollars found in traditional bank deposits (presented in detail by Milton Friedman)
- The second is the addition of wholesale banking transactions that create an incremental supply of USDs that doesn’t get captured in the official statistics of M2
It’s a difficult thing to believe, but no one really knows for sure where Eurodollars came from, but it’s generally understood that the market began sometime in the 1950s, and by the 1960s there was an unregulated monetary system blinking on the Feds radar. Consider this:
