The Eurodollar System: Why Dollars Outside the United States Move FX More Than the Fed Does

Every day, trillions of dollars are transferred through channels that remain largely unknown to the general public. While the Federal Reserve appears to be the primary controller of the dollar, the reality is that a massive portion of the dollar exists outside of the United States.

The way the system operates surprises even the most knowledgeable investors, as it manipulates the pricing of currency.

What Constitutes the Eurodollar System?

People are misled to believe that the eurodollar system refers to the euro currency and Europe. The reality is that the eurodollar system refers to the United States dollars that are kept outside the boundaries of the United States (i.e., kept in foreign banks).

After World War II, US dollar deposits began to be retained outside of the US. As US operations began to extend out of the United States, more dollar deposits were kept outside of the US.

What Does the Offshore Dollar Market Mean?

The offshore dollar market is a major part of what’s known as shadow banking. Lending of dollars to businesses and other foreign entities is completely outside of the Federal Reserve.

The Federal Reserve has control over dollars in the United States via interest rates and the supply of money, which is why traders closely follow macroeconomic indicators to gauge policy direction. However, the Federal Reserve has virtually no control over dollars in foreign banks (London, Hong Kong, etc.)

This also explains why increasing rates doesn’t always drive up the value of the dollar as some might expect. Large quantities of the dollar actually exist beyond the reach of the Fed.

Why the Eurodollar System Affects FX Markets

Experienced currency traders pay attention to the Eurodollar along with the decisions made by the Fed. Knowledge of that system is effective at predicting FX currency prices.

In times of economic distress, the demand for dollars often increases. Global banks begin to limit dollar lending, making them more difficult to obtain. This happened during both the 2008 financial crisis and the 2020 pandemic, and the Eurodollar system became even more restrictive while the dollar value continued to rise.

The Fed was forced to introduce currency swap lines to supply dollar liquidity to the Eurodollar system.

Dollar Funding Stress and FX Markets

When obtaining dollars outside of the U.S. becomes even more difficult, it is often reflected in the FX markets through sharp moves visible in forex quotes in real time. The dollar tends to appreciate. Many countries have to borrow in dollars but earn in local currencies, so the situation becomes even more problematic. They are forced to buy dollars while their currencies depreciate in value.

If you do not consider the Eurodollar and offshore dollar markets, the situation is often more surprising when you simply look at Fed policy. The Eurodollar system is where the pressure builds. Often, by the time the Fed responds, the FX markets have already adjusted.

This is why investors closely monitor the cross-currency basis swap market. It measures the premium foreign banks pay to obtain dollars offshore. An increase in this cost is an early warning indicator for stress in the eurodollar market.

Eurodollar Futures and Insights

For nearly four decades, eurodollar futures were among the most heavily traded interest rate futures in the world. They were retired in 2023 and replaced by SOFR futures, which now serve the same role: letting traders speculate on the future path of short-term U.S. interest rates. Eurodollar futures contracts also served as a measure to assess the state of dollar liquidity in the global market.

Interpreting Eurodollar Futures

A eurodollar futures contract was contingent upon the three-month dollar deposit rate in the offshore market. If SOFR futures are trading at a higher price, it is a sign that the market expects lower interest rates and an influx of dollar liquidity.

Conversely, if these contracts trade at a lower price, it represents higher implied interest rates and shows that dollar liquidity will become more scarce.

Active participants in this market often price in monetary policy shifts before they’re formally announced. This is because these contracts trade based on the real demand for dollar liquidity. This is evident through the trading activity of large financial institutions.

You can assess whether dollar liquidity is tightening or easing based on the slope of the SOFR futures curve. This helps you forecast anticipated currency moves before they are made public.

How Offshore USD Influences Global Currency Market Dynamics

The offshore USD market affects far more than just the dollar pairs, it reaches almost all major currencies. When getting USD to fund overseas operations is cheap, international actors borrow cheap USD to fund investments in higher-yielding assets abroad, driving up risk-on currencies like the AUD, BRL, and other FX pairs. These periods are typically characterized by increased carry trade activity.

When the Eurodollar system tightens, carry trades quickly start to collapse. High-yield currencies are sold, and USD are bought. This results in a sudden and sharp move in FX markets that seems out of pace with local economic activity. These FX moves are a reflection of the Eurodollar system.

Central Banks and the Eurodollar System

Central Banks outside of the US have to pay attention to the Eurodollar system. When funding in the Eurodollar system becomes tighter, other currencies face selling pressure. Many of these Central Banks have to maintain a reserve of USD to counter this effect.

The Fed does not always make a public response to the Eurodollar system. During the 2008 crisis and the 2020 Pandemic, the Fed established a SWAP line with many Central Banks. This allowed an outflow of USD from the Fed to calm the Eurodollar system and stop the increasing spike of the USD.

Important Information to Keep in Mind

The Eurodollar system turns the world currency market. The Fed has a role to play, but things happen in the offshore dollar market before any change in onshore markets. If you want to get an edge on Forex, you need to learn the offshore dollar market.

The offshore dollar market, SOFR futures, and dollar funding stress indicators all give a picture of future market movements that is far more valuable than listening to the Fed.