Eurodollar futures flagging year-end dollar crunch

By Gertrude Chavez-Dreyfuss NEW YORK, July 2 (Reuters) - The eurodollar futures market, which tracks short-term funding rate expectations over several years, is signaling funding stress by year-end for banks and corporations that could trigger abnormally high demand for U.S. dollars. In general, dollar demand rises as Dec. 31 approaches, as portfolio rebalancing and fund transfers require currencies like the euro and sterling to be converted to dollars. Eurodollar futures , a bet on the direction of the short-term London interbank offered rate (LIBOR), are one of the most heavily traded assets in the world. Investors hedge interest rate risk in this market. So far this year, parts of the eurodollar futures yield curve, which plots expected LIBOR rates as far as out as six to 10 years, have been inverted. The curve is slightly inverted from now until the end of the summer, which means the implied yield for the July 2020 contract exceeds those for August, September and October. The curve is also inverted from December to the summer of 2021. Normally, yield curves slope upward with nearer maturities yielding less than dates further out in time. Longer-term debt typically carries greater risk because of the higher probability of inflation or default. "What the inversion means is that people in the money market and eurodollar futures market are thinking there would be a tremendous demand for dollars as we approach the end of the year as companies and banks dress up their balance sheets," said Brian Reynolds, chief market strategist at Reynolds Strategy. "After a year like this with the coronavirus, there is probably extra demand for dollars," he added. At the height of the pandemic in March, demand for dollars soared as the prospect of shutdowns and economic contractions forced cash-short businesses to draw down loan facilities or seek safe U.S. assets as they ride out the storm. In the event of another dollar shortage, analysts said, the Fed would step in to prevent a full-blown crisis. "It's not a crisis, by any stretch, just a macro negative," Reynolds said. NOT THE FIRST INVERSION In June 2018, the eurodollar curve inverted, which suggested the Fed would have to cut interest rates at a time when it was in a tightening mode. In 2020, the Fed cut the fed funds rate to zero as the coronavirus pandemic caused economic devastation around the world. "In this renewed zero-interest-rate policy, huge-QE (quantitative easing)-flood-of-liquidity environment, what this inversion represents is the market saying, what flood?" said Jeff Snider, head of global research at Alhambra Investments. "The market is telling you that the risks of renewed illiquidity, which could result in another possible LIBOR spike, remain significant right at this moment." A telling sign is the "hump" in the yield curve, analysts said, with the December 2020 futures contract up at about 30 basis points, compared to the September 2020 contract at 27 basis points, and 20 basis points for March 2021. Typically, yields on those contracts are in line, said Albert Marquez, interest rate broker at the Chicago Board of Trade. "And it's not. So basically there's a difference of about four ticks among the contracts," he added. However, spikes in the yield for December contracts are normal because expectations of year-end funding issues are generally priced in, he said. A typical derivatives trade covering the year-end or so-called "turn" in money market lingo is a "butterfly swap." According to Reynolds, the yield on this trade has increased to a record six basis points. Reynolds said he had never seen the "turn" priced so high and "this far away from year-end." "This tells you that people are anticipating year-end stresses because the demand for dollars from the banks will exceed supply." (Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Richard Chang)