The Difference Between Eurodollars and M3 Eurodollars

My friend Bart at Nowandfutures.com and I have discovered the cause of the discrepancy between his, and presumably John Williams' estimate of Eurodollars for their M3 estimates, and the BIS reports of Eurodollars.

The Fed's estimate seems to be limited to foreign branches of US banks only.

The Board of Governors of the Federal Reserve discontinued the Weekly Report of Eurodollar Liabilities Held by Selected U.S. Addressees at Foreign Offices of U.S. Banks (FR 2050; OMB No. 7100-0068) in March 2006. In November 2005, the Federal Reserve decided to cease collecting, constructing, and publishing the M3 monetary aggregate, effective in March 2006. As a result of the Federal Reserve's decision to cease constructing the M3 monetary aggregate, data collected on the FR 2050 are no longer needed.

This voluntary report collected two items of daily data once a week: (1) total non-negotiable Eurodollars and (2) negotiable term Eurodollars held in custody accounts, both payable to U.S. addressees other than depository institutions and money market mutual funds. The primary use of the data was to construct the Eurodollar component of the M3 monetary aggregate. The data were also used for analysis of depository institutions' funding practices.

This puts a more practical cast on the discontinuance of the M3 report.

As the BIS reports make very clear, the Fed's method was greatly underestimating the amount of dollars held by overseas banks, which is how the marketplace had come to define Eurodollars.

"A dollar-denominated deposit made in foreign banks or foreign branches of U.S. banks. Depositors sometimes transfer their funds to European banks in order to take advantage of higher interest rates. The Eurodollar is one type of Eurocurrency. Eurodollars are US currency deposited in banks outside the United States but not always in Europe. Certain debt securities are issued in eurodollars and pay interest in US dollars into non-US bank accounts. Eurodollars are a form of eurocurrency."

I think the term Eurodollars outgrew its origins, as it had come to refer to all dollars held overseas outside the jurisdiction of the Fed and the US Federal Government.  As you may recall, eurodollars started as a movement by certain entities to hold their US dollar assets outside the Fed to avoid the freezing and seizure of their assets, but it become much more broadly used as the dollar grew into the global reserve currency.

The Fed was faced with the choice of incurring the expense of going back and correcting their numbers to reflect the broader definition.  And since they have no authority over non-member banks, they would have to rely on BIS to provide them the data.  Their decision was to either redefine M3, or simply discontinue it.  They chose the latter.

So to avoid confusion, Eurodollars will refer to any US dollar held as foreign currency as defined by the BIS. M3 Eurodollars will refer to the discontinued series by the Fed which estimated the dollars held overseas at branches of US banks.

I would agree with the Fed that their definition was becoming quaintly irrelevant to the markets. I estimate that today the M3 eurodollars represent less than half of Eurodollars held around the world if one includes official reserves as well as reported commercial bank holdings.

Since it is the total amount of dollars held overseas in liquid form that is of interest to us, we will be using the BIS data to track eurodollars as we have been doing.  It does render M3 estimates less interesting however.

LIBOR is in Backwardation and Significantly Divergent from Effective Fed Funds

LIBOR has ceased to function as a reliable benchmark suitable for commercial and residential loans in terms of US dollars.

It is in backwardation with an inverted yield curve, and has significantly diverged from the Effective Fed Funds rate.

This is most likely because of the Eurodollar 'short squeeze,' as shown by the record TED spread, and the inappropriately small sample size of LIBOR reporting banks.

This is all a symptom of the greater issue of the US dollar, which is no longer suitable as the reserve currency for global central banking.

The Federal Reserve is no longer able manage the dollar to simulate the stability of an external standard, given their decision to ignore nominal money supply growth. Their current mandate instead focuses them on purely domestic economic metrics that may be inappropriate for the changing state and requirements of exogenous economic systems, unless those systems are willing to subordinate their fiscal and monetary discretion.


What is LIBOR?

The London InterBank Offered Rate, or LIBOR, is the average interest rate charged when banks in the London interbank market borrow unsecured funds from each other.

There are different LIBOR rates for numerous currencies, including U.S. dollars.

The world banking system has adopted the LIBOR as a benchmark for short-term, interbank loans.

The LIBOR rates are now internationally recognized indices used for pricing many types of consumer and corporate loans, debt instruments and debt securities across the globe, and is the reference for many loans including the vast majority of Interest-Only Loans in The United States.

LIBOR rates are fixed every UK business day by the British Bankers' Association BBA.

The Fed Funds Target Rate, America's benchmark interest rate, and the U.S. Prime Rate are managed by America's central bank: the Federal Reserve.

The LIBOR rates, however, are fixed by a relatively small group of large private international banks themselves

The Bank of America
JP Morgan Chase
Citibank, NA
Bank of Tokyo-Mitsubishi UFJ Ltd
Barclays Bank plc
Credit Suisse
Deutsche Bank AG
HBOS
HSBC
Lloyds TSB Bank plc
Rabobank
Royal Bank of Canada
The Norinchukin Bank
The Royal Bank of Scotland Group
UBS AG
West LB AG


Is LIBOR a stable benchmark of short term money rates?

There is a case to be made that LIBOR is an inappropriate reference to be used for commercial short term rates because it is subject to distortions given the relatively selective sample size of the reporting banks. One or two troubled banks can significantly impact average LIBOR.

The spreads between the highest and lowest quoted rates in an efficient measure should be narrow and convergent. Recently the spreads among the LIBOR quoting banks have become shockingly wide, reflecting the non-competitive nature of the short term interbank loans given the massive intervention by the central banks as they flood the markets with loans designed to recapitalize the banking system.




Here is the detail of the composition of the 3 Month LIBOR. One might expect this to be a scorecard of default risk amongst the reporting banks from the perspective of their peers.





How does LIBOR compare to a short term rate measure such as Effective Fed Funds?

There has been a strong correlation between the Effective Funds Rate and LIBOR dollar rate as one might expect.



However, recently there is a growing divergence between LIBOR $US rates and the Effective Fed Funds Rate. This is a symptom of distress in the banking system and shows the inappropriate character of LIBOR for use as a benchmark for the commercial and residential loans markets.




And perhaps most surprisingly, the LIBOR dollar rate curve is now inverted.


How can LIBOR be Inverted when the Effective Fed Funds Rate is steepening?

This is most likely a symptom of fear of risk of capital return in interbank lending. It may also be a sign that the current eurodollar short squeeze is expected to dissipate, as it will as the capital markets revert to the means and efficient operation.



One might also pointedly ask what the G7 will be doing to address the distortions being introduced into the European banking system by the US dollar and its shortages due to the precipitous deterioration of US dollar debt assets held by European banks, as the solution for this seems to be eluding the bureaucrats in Brussels.

As a hint, the US dollar, like LIBOR, is being used inappropriately and the basis for international trade must change to a more stable measure.