Current macro environment is characterized by uncertainty in Euro zone sovereign debt crisis. On September 5, 2011 Gold has risen to all time high of 1900. Since then it has fallen to 1638 as of October 7th 2011. This fall is blamed on liquidation or risk off trade. Consequently other dominoes fell lock in step. These include, emerging market currencies, base metals, emerging market equities. In this chaos Dollar emerged as winner and long dated rates rallied. There is one interesting thing that can point to liquidity stress due to euro zone crisis plaguing the financials in this euro area is USD 2y swap spread. Once a trader reckoned to the fact that USD 2y swap spreads indicate the level of liquidity and 10y swap spreads determine the credit quality in the financial markets. Since the September 5, we have started seeing immense chaos and rising volatility in the financial markets. During the same time 2y swap spreads have widened to a level just shy of 40 bps from the lows of 15 bps. At the same time, 10y swap spreads has changed very little. This I do not understand why? But, there is a clear evidence of liquidity crisis. Now this effect is playing into rising short term rates and hence fall in front end euro dollar futures prices. Definitely the liquidity crisis is breathing some action into this area of the market where prices have been very much anchored to feds zero interest rate policy.
