Finding Opportunity In Eurodollar Spreads

Includes: BCS, JPM, PFF, PGF, PGX, WFC
by: Martin Snow

Eurodollar futures are based on LIBOR. (London InterBank Overnight Rate) Because of global uncertainty affecting banks, the debt crisis escalating in Europe could possibly lead to a sizeable drop in confidence among European banks.

In my opinion, even the current round of negotiations among the EU member countries and their finance ministers does little to alleviate the underlying issues that brought Europe to this point. Even after the recent EU package was agreed upon, the Italian bond market, which serves as a bellwether for the European financial union, is flashing warning signals as the Italian bond yields rise. According to The Financial Times surveys, European banks are too feeble to withstand sovereign defaults (ibid.)

The combination of escalating debt and institutional weakness may effect a reluctance to lend, thereby affecting both the cash and nearby futures contracts in the Eurodollar market.

The beginning of banks’ reluctance to lend began in the fall of 2008 following the Lehman Brothers crisis. The Overnight Interbank Spread (OIS) rose from 4 basis points to over 150 basis points, reaching their widest levels since the inception of the OIS market. The recession now stalking Europe’s weakening economies may lead to a Greek default. The U.S. and Asia would likely be indirectly affected by a freeze in global credit markets, which happened during the Lehman Brothers crisis.

In my view, Germany’s stated intention not to back the ECB plan and proceed by way of orderly defaults, will exacerbate the potential for a credit meltdown which would require central bank intervention to restore liquidity. Such an event would most-likely put pressure on bank stocks such as Wells Fargo (NYSE:WFC) or J.P.Morgan Chase (NYSE:JPM). Some of the bank ETFs likely affected as well might be (NYSEARCA:PGF) which has holdings such as J.P.Morgan Chase, Barclays (NYSE:BCS) and Wells Fargo. Similar ETFs include (NYSEARCA:PGX) and (NYSEARCA:PFF).

Given current market conditions the eurodollar market may present an opportunity then that could benefit from short-term weakness and long-term debt.

Investors might consider a Calendar Spread to trade this market. A Calendar Spread is a spread trade involving the simultaneous purchase of futures or options expiring on a particular date, and the sale of the same instrument expiring at another date. Thus the Calendar Spread strategy may benefit from the spread widening in the front months due to fear and market skittishness, which affects the reluctance to lend, and the market rally in the further away months due to the factoring of lower interest rates based on speculation of slower growth. Investors might consider selling the January 2012 (GEF2) contract currently trading at 99.27 and buying the September 2018 (GEU8) contract currently trading at 96.79.

There is a substantial risk of loss in trading futures and options. Past performance is not indicative of future results. The information and data in this report were obtained from sources considered reliable. Their accuracy or completeness is not guaranteed and the giving of the same is not to be deemed as an offer or solicitation on our part with respect to the sale or purchase of any securities or commodities. PFGBEST, its officers and directors may in the normal course of business have positions, which may or may not agree with the opinions expressed in this report. Any decision to purchase or sell as a result of the opinions expressed in this report will be the full responsibility of the person authorizing such transaction.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.