The chart below captures one of the biggest themes driving markets lately: traders are scaling up bets that the Fed will have to hike rates sooner as improving economic data becomes increasingly at odds with the central bank’s promise to keep short-term interest rates low (i.e., monetary policy accommodation maxed out) long into 2015.
That’s why investors are piling into short positions in futures and options on eurodollars (3-month dollar deposits held in banks outside the United States). Eurodollar contracts move inversely to yields, so these short positions will pay off if interest rates on those 3-month deposits are higher in the future than where the market currently prices them today.
The release of Commitments of Traders data on Friday revealed that through the week ended last Tuesday, investors’ collective short positions in eurodollars reached an all-time high.
The chart goes a long way toward explaining the turmoil in global financial markets last week, which was exacerbated when many leveraged players covered short positions in the interest rates space, sending eurodollar contracts as well as U.S. Treasuries surging and yields plummeting.
While many are quick to ascribe the global market sell-off — which hit U.S. stocks and emerging-market currencies, among other risk assets — to the prospect of further withdrawal of Federal Reserve liquidity from the markets as the central bank scales back its bond buying program, the opposite concern may have had a bigger effect.
To be clear, the unwinding of leveraged positions as traders decided these outsized bets on earlier-than-expected rate hikes were getting overdone was a key feature of last week’s turmoil, and it suggests that positioning became a bigger concern than the actual likely course of Fed policy itself.