Just as a drowning person will grab an anchor if thrown overboard, traders latch on to any piece of overweighted flotsam tossed their way. Take the weekly Commitments of Traders Report (COT) produced by the Commodity Futures Trading Commission (CFTC). The urge to believe backward-looking net positions held by various classes of traders can be useful in assessing market imbalances and in forecasting market turning points is extreme. However, unless a speedy visit to the ocean floor was on your to-do list, the temptation should be resisted.
This is not to say we are absent the occasional datum where, to continue our nautical metaphors, everyone was on one side of the boat and the damn thing flipped over. But a series of anecdotes does not a theory make. No, it is simply a case of confirmation bias where you simply remember what worked and forget about the rest. As discussed many years ago (see “Making A Commitment,” June 1998), the chain of causation for COT data is wrong.
- Economic value changes;
- Price moves to reflect these changes and generally overshoots;
- Trend-following traders accumulate positions in the direction of the trend and in grand market fashion become too long at the highs or too short at the lows; and then
- The market reverses as the trend-followers’ collective folly is exposed
In addition, the COT data behave differently across markets and cannot be pooled freely for cross-sectional analysis. To engage in a little anecdotal evidence, ask why managed funds are almost never net short commodities such as silver or RBOB gasoline or why non-reportable traders are never net long corn. Some futures markets are used primarily as vehicles for commercial traders to fix the price of forward deliveries, some are used primarily to speculate and some are used primarily in lieu of less-transparent cash markets for purposes of price discovery.
The eurodollar market
Eurodollar futures deliver 90-day time deposits of dollars held outside of the United States. The price of the contract determines the implied add-on yield paid or received for the three months following the expiration. As such, the contract can be used to bet directionally on the direction of short-term interest rates and this and trading the spread between Eurodollars and Treasury bills were its primary uses for a few years following its December 1981 introduction (see, “See TED Spread,” February 2004).
It did not take long for the market to find its primary use as a tool for pricing and hedging interest rate swaps by trading strips of contracts whose collective implied yield defined the fixed leg of an interest rate swap. A short position in one of these strips means the seller is a “fixed-rate payor” or borrower in the futures market at the strip’s implied rate; the long position is a “fixed-rate receiver” or lender at the strip’s implied rate.
As a result of this usage, the Eurodollar and similar futures such as Euribor have been the largest futures contracts in the world for years despite a near-complete lack of short-term interest rate volatility since the end of the financial crisis. The high-low range for three-month Libor has been less than six basis points over the year prior to this writing but average daily trading volume has been more than 2.32 million contracts. If this is speculative effort, we really ought to find some better speculators.
The ongoing effort by regulators to move interest rate and other swaps onto centralized clearing platforms including those operated by the CME Group, the InterContinental Exchange and Eurex will bring an increasing percentage of formerly over-the-counter swap positions into futures markets, albeit fitfully. Here they will be counted in the COT reports.