Central Banks Pour Gasoline On the Fire

The US Treasury completed a re-opened auction of 10-year government bonds yesterday into what was an otherwise uneventful day in US markets. Just before the auction was completed, the expected 10-year yield ("when issued") was trading about 1.516%, an extremely low level itself. Once the auction results were announced, it became clear this auction was anything but uneventful. The bid-to-cover ratio, a measure of the amount of bids submitted and therefore a proxy for demand, hit 3.61, the second highest on record. As a result the posted yield for the auction came in at 1.459%, or almost 6bp below (or inside) the "when issued" yield. That may not seem like much, but it is a huge spread in the world of treasury auctions. That 1.459% yield is a record low, but only 51% of the auction priced at that record low (treasury auctions are Dutch tenders). The lowest bid accepted was actually 1.36%, meaning half of the auction resulted in accepted bids between 1.36% and 1.459%. Fully half of the re-opening was not only more than 6bp inside of "when issued", half the debt was sold at even lower record lows, and not by a little.

Meanwhile, on Tuesday, July 10, the French government sold EUR6 billion in short-dated debt at negative yields for the first time in history. In Germany, much of the shorter end of the yield curve fell below zero, with the 2-year note falling as low as -0.02% and the six-month bill as low as -0.065%. In Switzerland, the 2-year bond dropped to -0.38%, a new record negative yield.

In June 1983, Ben Bernanke authored a paper titled, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression". In his conclusion, he noted:

"Institutions which evolve and perform well in normal times may become counterproductive during periods when exogenous shocks or policy mistakes drive the economy off course."

Part of that "counterproductive" behavior of financial firms in the 1930's was the overwhelming tendency to hold nothing but the most liquid and negotiable paper, a trend that lasted long after the worst of the collapse had passed. As Bernanke and other authors have noted in the course of studying the Great Depression, as monetary authorities sought to ease liquidity conditions they failed to see that their own actions had not taken this liquidity preference into account. As a result, the more money that was created and pushed into the financial system, the more money simply went toward the purchase of the most liquid and acceptable collateral - US treasuries and gold.

In fact, the trend toward collateralization then was another counterproductive trend because of the spillover effects it had on borrowers. Again from Bernanke's June 1983 paper:

"A useful way to think of the 1930-33 debt crisis is as the progressive erosion of borrower's collateral relative to debt burdens."

Bernanke, of course, was speaking about the effects of liquidity preferences in the real economy. Banks were not willing to hold mortgages, for instance, because they had little use for the real estate pledged as collateral. As their preferences shifted away from these illiquid types of collateral, they saw these collateral assets as less and less "valuable", yet the principle "value" of the debts remained the same. This growing chasm between the debt burdens and diminishing collateral values resulted in that growing liquidity preference over every other consideration. If borrowers could not pledge the "correct" collateral, they would not even be considered for loans. Worse still, they would actually be put in the front of the line for loan extinguishment since this liquidity preference shifted lenders' collective perceptions of where risks were highest.

In 2012, there is undeniably some of this same process being carried out in the real economy, but by and large this is mostly seen as contained within interbank markets. The "progressive erosion of borrower's collateral relative to debt burdens" is seen exactly in the failure of interbank money markets to function properly. Banks, including the European banks, are still overly reliant on short-term funding, meaning they are very dependent on interbank borrowings. While there once existed a thriving regime of unsecured lending markets (in euros, eurodollars and dollars), hardly any interbank business is carried out without collateral security anymore. As the unsecured market has receded into just memories of past glory, the relative interbank debt burdens have greatly increased as the system shifts further toward collateral. The result has largely been as Bernanke described the 1930's, as institutions that once functioned normally and "productively" (at least in terms of fostering asset inflation) are now counterproductive toward the efficient functioning of the entire system.

To combat these contrary trends, central banks turn to their old stand-bys, increasing the stock of money. In the US that took the form of QE's, while in Europe the ECB has conducted longer-term lending operations known as LTRO's. In both cases, as I have argued before, increasing the stock of money has itself been counterproductive since it hastened the decline in the velocity of interbank money flow. But it also adds to the parallel problem of putting banks into increasingly binding circumstances.

In the week since the ECB's decision to drop its "deposit rate" to 0%, about EUR484 billion, almost 60%, has gone elsewhere. Any guesses as to where all that money has gone? Given the absolutely strong demand for government paper since the ECB decision, it is pretty clear that banks are following the path laid out by Bernanke's 1983 description of nonmonetary effects of the Great Depression. No doubt the ECB had intentions of pushing money out of its deposit program and back to the periphery, but it cannot seem to overcome the continued preference for the most liquid issues. These preferences, much to the ECB's dismay, are now engrained by the constant state of liquidity interference coming from the central banks themselves.

The massive deposit balance, which had been near EUR800 billion since early March 2012, and the corresponding and massive Target II imbalance, are tied to the retrenching flow of money away from PIIGS nations. As banks in the north of Europe pull money out of the south of Europe, they are playing exactly this game of liquidity preferences above all else. In other words, banks are simply looking for a safe place to park money because they have no incentive to move money into real world credit beyond any security that cannot be repledged as collateral - and that is limited, by regulatory framework, to OECD government bonds, and further limited by the state of fiscal affairs in some of these OECD nations. The strain this process places on the rest of the system is immense since it forces any institution that is seeking short-term funds (meaning every modern bank in existence) to a crowded trade of government debt (which politicians are intentionally using as cover for their own ends).

In the intersection of the crowded collateral trade and the zero bound of interest rates we end up with elevated stress at a moment when it can least be diffused. This distress can be manifested in two ways. First, as money is pushed out of its safe harbor of central banks, either at the ECB or at the Fed if it ever decides to follow the ECB (it has not given any indication yet that it would lower its IOER rate), it simply flows to these "blessed" securities that conform to the current state of liquidity preferences. That, in turn, suppresses interbank lending rates as money floods just to find a safe harbor home, straining those firms that actually lend cash in the growing tide of central bank-led rate suppression. As short-term rates across the credit spectrum drop toward zero, and even below zero, those cash lenders pull back from lending.

This occurred starting April 2011 in the US as the Federal Reserve was reducing the supply of US treasury collateral through QE at the same time a change in FDIC assessments of banks' reserves at the Fed pushed a flood of money into US repos. Dollar liquidity became scarce as some lenders pulled back due to low rates, and borrowers were forced into the voluntary capital destruction of purchasing collateral at negative yields. The system was not able to circulate dollars widely and they ended up concentrated in a few hands, the very problem that occurred in the 1930's financial system.

This was not the first time US repos experienced circulation issues. As repo rates fell toward zero in September 2008, we saw a massive spike in repo failure-to-delivers. These repo fails were, somewhat counterintuitively, limited to the treasury repo market (as opposed to private MBS or agency debt repos which were being labeled uniformly as "toxic"). As the rate on some repo lending hit 0%, the effective cost of failing to deliver was the same as borrowing that security at 0%. The problem with those failures, apart from the stress it placed on repo trust at the worst possible moment, was that they interrupted the daisy chain of rehypothecation that the system had been, and still is, dependent on to flow funds within interbank markets. These suppressed short-term rates end up suppressing real liquidity because the ability to move money to where it is most needed gets that much more difficult.

In Europe, certain central banks have in place programs to mitigate these types of repo fails - the Bank of England, for example, creates and trades phantom bonds for any security it perceives as in short supply, while the Bundesbank withholds German bunds from auction to maintain a steady supply should there be some disruption. But the repo market across Europe is fragmented and even more opaque than in the US. It is hard to gauge what impact a serious increase in repo fails might do in, say, Spain, Italy, or any national liquidity system that is already under tremendous duress. With money already flowing out as Northern banks pull back, and some Southern retail deposit-holders flee, disruption to collateral devastates the ability of the periphery to pull any money back - even from the ECB.

The role of repo failures may have already played a part in setting the Greek system on fire in early 2010, way back at the beginning of this current crisis iteration. In November 2009, repo fail instructions were directed to be held into the next settlement period, for up to 10 days. That made market makers happy in that they would have time to cover any short positions that were opened on behalf of counterparty fails. But banks funding in Greek repos were decidedly against the plan because it essentially forced fails into an auction process. According to the European Repo Council:

"The key objection to the forced auction in Greek government securities was that dealers, including those who went short in the process of market-making, faced potentially unlimited borrowing costs.This problem may explain why the auctions were generally unsuccessful and were suspended.

"These problems have made primary dealers unwilling to quote for fear of going short, thereby severely damaging repo and cash market liquidity."

As a result, repo liquidity dried up almost completely and hedgers seeking to buy protection through shorting instead diverted their money into buying credit default swaps on Greek debt. In other words, at the very least, a change in the repo mechanics driven by fails may have played a significant role in igniting the Greek fire of 2010.

Getting back to last week's ECB rate decision, by indirectly pushing short-term rates so across so much of Europe the ECB is risking setting off some heavy unintended consequences. A rise in repo fails will certainly strain what interbank liquidity remains, and there is no way of predicting how that strain can and will get transmitted. About the only prediction we can make with certainty, is that the transmission of strain will not be helpful in any way.

The second measure of stress from low short-term interest rates is that progression of voluntary capital destruction. For the sake of operational liquidity, banks are forgoing any return on some assets, short-dated as they may be, just to be able to access some kind of liquidity to continue to fund their massive maturity mismatch. In addition, banks appear to be expanding this search for collateral at maturities past two years (in the case of Swiss bonds, the five year note has been consistently negative in its yield), further expanding the maturity mismatch that has created so much havoc already.

In Chairman Bernanke's 1983 construct, these interbank borrowers play the role of farmers and small businesses in 1930's. Stressed by the constant liquidity preferences of institutions that have actually obtained sufficient funding, these weaker banks are forced into more and more desperate measures that ultimately leads to total relief; i.e., liquidation. In the modern case of interbank borrowers, that would mean margin calls on the asset side of their balance sheet or pledging even more collateral until there is little left to satisfy more senior liability holders (if a bank pledges too much collateral, short-term lenders end up far more senior in the credit structure than even deposit-holders, a less than ideal situation for both an individual institution and the financial system). The voluntary destruction of capital just to maintain even this weak state is just more pressure for the pressure cooker, especially since banks themselves are not equipped to handle a sustained negative carry environment. Nor are central banks equipped to combat such a state.

For all the ink spilled on the Great Depression and banking crises, central banks have almost universally demonstrated an inability to comprehend the full state of crisis. In so many of these measures, the deposit rate cut being just one in particular, it seems as if central banks are using a two-dimensional battle plan in a three-dimensional battle space. The nightmare scenario for any central bank is certainly Fisher's paradox: deflation concurrent to over-indebtedness. The central idea to Fisher's paradox is that the more borrowers seek to alleviate their indebtedness, the more indebted they become. Conditions are ripe for Fisher's paradox, but they only exist within the financial economy itself. The three-dimensions of the modern bank crisis battle space is to separate the financial economy from the real economy.

Central banks have perhaps convinced themselves of the notion that the banking system and the real economy are fully inseparable. But they are wrong on that account. There are hugely deflationary pressures building within the banking system itself, as there have been largely unabated, for going on five full years. Those deflationary pressures have not had even the slightest inkling of infecting the real economy. And let me be very specific in what I mean, as it is the most important point in today's environment. Deflation is a currency disease where economic agents hoard currency above all else. There have been no lines of people waiting at banks to withdraw hard cash from even Spanish banks - at most they are simply transferring deposits or assets from one bank to another. The preference for actual currency remains completely undisturbed.

In the 1930's, the general population rushed headlong into a massive banking panic because the desire to hold dollar bills in physical cash form was emotionally tied to the potential losses that might be suffered in a bank failure. In 2012, the only monetary hoarding that has taken place, or is taking place, has been in interbank currency. All the nasty deflationary consequences of Fisher's paradox are playing out solely within the financial economy itself. The maturity mismatch of banks over-reliant on short-term funding is the modern equivalent of over-indebtedness. Thus, as banks seek to alleviate this condition, the more they struggle to find a way to fund themselves through repos, the more difficult and dangerous it becomes as the trade for limited collateral gets ever more crowded.

Central banks, demonstrating their two-dimensional thinking, pour gasoline on this fire of an interbank paradox by believing that increasing the stock of central bank reserves is a perfect substitute for general liquidity. They are playing to the idea that the real economy might be in danger of currency deflation when it is only the financial economy that is burning down because of it. As each measure of intervention assumes to keep deflation at bay, it spawns new combinations of financial economy deflation and over-indebtedness, forming a perfect feedback loop where each iteration of liquidity devolution feeds into, and guarantees, the next iteration.

The problem from the start of this crisis in 2007 has been about the means and method of circulating money. In the real economy that has meant a shortage or diminishment of jobs and wage income, the most efficient and healthy method of monetary circulation for any economy. In the financial economy, the system has been unable to replicate the scale of available financial collateral to replace the change in preferences and views about what constitutes "acceptable" collateral. Without fixing this problem new money not only does not circulate as desired (remember central banks still actually believe that if money would circulate as desired within the banking system it would lead to credit growth, increased inflation expectations, and thus real circulation in the real economy) within the banking system, it actually adds to the strain of financial economy liquidity. Worse yet, that strain begins to echo into the real economy as investors begin to perceive these two-dimensional, mismatched liquidity measures as a real change in investor expectations.

In the ultimate irony, if Fisher's view of the structure of interest rates is correct, then the scale and pace of the reduction in interest rates across the world supposedly signals expectations of deflation ahead, instead of the change in liquidity preferences and mechanisms. What is really a supply and demand problem of financial instruments may end up becoming the very thing that central banks have been fighting so hard to avoid, meaning that every measure they undertake is pushing them closer to realizing the result they so abhor - Bernanke's paradox.

Chairman Bernanke was correct when he noted in 1983 that nonmonetary effects can be very powerful in determining the course of both the financial economy and the real economy. The system that performed so well at generating asset inflation just a few years ago has become a dead weight on the entire global economy, especially as policies and interventions intended to resurrect that inflation capability continue to create chaos and distortions. The real tragedy lies not just in the inability of central banks to fix what ails, but in how central banks and monetary policymakers cannot seem to realize that there can be separate courses for the financial economy and the real economy. That which they fear the most, deflation, can actually be useful in the sole context of the financial economy in bringing about the long-delayed, but sorely needed, adjustment away from the monetary edifice of the artificial economy. And it would not have to lead to true deflation in the real economy, meaning Fisher's paradox would remain where it really belongs.