Central Banks Keep Overlooking What They Already Don't Know
It was no surprise the FOMC failed to find its own exit this week given that a few days earlier Deutsche Bank announced yet another restructuring including massive layoffs. It doesn't appear as if any of those job cuts will be applied to US operations, which seems to render this a quite curious correlation with domestic monetary policy. If you like, you can substitute Citigroup's 5% decline in FICC "revenue" this quarter, or Jefferies Group 50% collapse in fixed income losses (tied to the corporate bond bubble, no less). It's all one and the same.
On the surface, the relationship between banking and the Fed seems to be just that straightforward. In very general terms, interest rate targeting is supposed to reduce the "cost" of funds for banks so that they can "earn" a greater spread to the assets they hold or will hold. If only it were as easy as economists believe.
Back in early July, Deutsche's new co-CEO, John Cryan (soon to be lone CEO), wrote an internal memo spelling out why it was he was brought on in replacement. It was barely mentioned and certainly has not been appreciated, but the letter to his employees included, "The investment bank's securities and derivatives trading businesses can't continue to soak up capital." and, "Reducing this reliance should not place us at a competitive disadvantage as the market has anyway already moved in that direction."
If you get to the guts of the global wholesale financial system, eurodollars in preponderance of the major "reserve currency", you realize it isn't much about bank reserves and almost nothing of Federal Reserve Notes, the physical stock of cash that so often accompanies conventional thoughts about what a bank even is. No, the wholesale system is money dealing, loosely speaking, conducted via warehouse operations in the investment bank (prop trading) and derivatives - just the sort of "capital soaking" that Deutsche Bank no longer wants to do as much of. As Cryan was getting at, the rest of the "market" has already shifted away which is a very good hint as to why his predecessors are no longer on the job.
At Credit Suisse, another of the former eurodollar holdouts until that, too, cost the CEO his job, the portfolio reset has already been dramatic. At the end of Q3 2014, the bank reported $54 trillion in gross notional derivatives in its "dark leverage" book, including $47 trillion interest rate swaps and $1.4 trillion CDS and credit derivatives. Through the reported end of Q2 2015, those exposures have declined by nearly one-third just in nine months' time. That would suggest, for whatever we can take from gross derivatives reported, a serious decline in balance sheet liabilities extended into the wholesale system.
From that standpoint, when the Treasury Department released its monthly TIC figures (which attempt to reconcile foreign activity with the domestic view of dollar flows) the nefarious "dollar" run and its several waves are further illuminated and collated. There were several noteworthy movements, but the most was in relation to something left over from June. The total net "flow" (TIC approximations total foreign buying against total foreign selling in any calendar month) for July was barely positive; just $4 billion. That wasn't nearly as bad as January's -$39 billion, but the difference is overstated by the nature of the data. From the middle of 2002 through the middle of 2007, the average monthly "inflow" was $78 billion; the average from 2005 to the middle of 2007 was $102 billion.
The first major reversal in that trend occurred in the month of August 2007. At -$38 billion, both the private "market" for dollar assets and central bank holdings suddenly found themselves "short." Buried further within the TIC figures, and there is a lot of volume and different pieces to the series, is something called "in banks' own net dollar-denominated liabilities." The statistic is as it sounds, giving us at least a partial view of what global bank balance sheets are doing to extend the "global dollar short."
Prior to August 2007, that number had been negative on a few occasions with no outward upset or dismissal in either TIC or anything else. There had been a $127 billion reduction in reported bank dollar liabilities in June 2006 without any outward disruption (whether or not that relates to the top in the housing bubble isn't quite clear). But when August 2007 came around and banks reported an $80 billion drop, all hell broke loose. It hasn't, as I have written repeatedly, been the same since.
That suggests that banks, TIC flow or UST's are not by themselves enough of a single factor to cause problems; there has to be a combination of negativity and force. Thus, the usefulness of the overall TIC data is to suggest when some common permutation is present and, more importantly, at work.
That much we can infer just by naked observation of "markets" all around the globe these past fourteen months, including the US. Stocks may have shrugged off the August 24-25 "crash" but in reality stocks haven't gained much going back to last July. Neither have corporate credit prices, in fact just the opposite. The junk bubble in the US is under serious strain, and that threatens not just further episodes of general liquidation like late August but actual economic suspension. Leveraged loans, the insipid foundation of the corporate credit bubble in its heightened state following QE3, has seen issuance decline by almost one-fourth in 2015 YTD though yields have (via index calculations) risen just 1% nominally. Unlike stocks to mid-September, junk debt of all kinds hasn't much recovered from the August lows.
Since leveraged loans are the syndicated, institutional cousin to generic junk bonds, there is certainly a high degree of banking and wholesale funding tied into them. You could figure that much just from the obvious price correlation between the S&P/LSTA Leveraged Loan 100 Index and, of all things, the Japanese yen. The infamous and mythical "carry trade" is in some part lore but also very real as one aspect of transferring wholesale banking dynamics (traded liability chains) into asset prices and even real economy outlets.
If we trace the global upset in August backward closer to its local root or genesis, we find "dollar" rates and implications that had been previously rising (owing to past conditions, which I'll get to below) but taking a sudden turn around July 7th and 8th. LIBOR, particularly 3-month LIBOR, suddenly surged and hasn't really looked back since. That followed a highly unusual occurrence in repo markets where, as I chronicled last week, GC repo rates retraced almost exactly and eerily their prints from the prior quarter-end. Repetition of this kind is, as chaos theory assigns, non-random and thus significant.
The element regarding the quarter-end is one that has repeated in every crisis of the past two decades (and even before that, as there is a very distinct and financial reason stock crashes typically occurred in October; the seasonal flow of real money tied to agriculture and global trade produced a significant bottleneck that, via call money, tied directly to asset prices. The question now is why that pattern, as October 2008, has repeated beyond any modern operative condition that should break such a deficiency) which suggests typical window dressing can be a significant fault-line under the right sort of conditions. Here, again, TIC finds exactly that weakness.
For the past several quarters, really dating back to 2013 and the larger "dollar" outbreak supposedly relating to "taper", the TIC estimates have shown bank dollar liabilities collapsing right at the quarter end. For instance, in Q3 2014, the monthly flows were, +$123 billion in July, +$13 billion in August and -$201 billion in September, which was a then-record decline. Thus, the net contraction in bank liabilities (as reported) was -$64 billion for the quarter. Is it any surprise that the disorderly and illiquid events of October 15 occurred directly after?
The pattern was repeated in Q4, but with further degradation; +$173 billion October, -$26 billion November (likely why December was such a bad financial month) and a new record -$239 billion December. The Swiss National Bank was forced off its euro peg just, once again, two weeks after that quarter ended, all due to not euro problems as is conventionally believed but the "dollar." That quarterly total of -$93 billion was the worst since Q1 2010 (and we know what followed immediately upon that).
The first quarter of 2015 was somewhat of a respite. The quarter-end liability drop was "only" $128 billion in March, about half of the prior two. Overall, reported bank liabilities were just about flat for those three months. Coincident to that, oil prices rose, the treasury curve steepened, eurodollars were sold (that curve also steepened) and for a while it was looking if not brighter at least somewhat more optimistic, certainly in comparison to the very dark days of December and January.
In terms of these bank liabilities covered by TIC, Q2 didn't really get off to a great start. The inflows in April and May were behind the pace of prior quarters, which meant that any reprieve coming out of the milder "dollar" in Q1 wasn't built on an actual retracement but rather just less acute negative funding pressure. In June, banks removed nearly $210 billion, the second biggest monthly decline, similar to the scale of September and December 2014. Like a lit fuse, what followed in July and August was just as that which followed September and December (and in many respects worse, as the accumulation of these "events" is self-reinforcing in this perpetual withdrawal of bank liabilities in the first place - math as money). So the specific outlines of these "dollar waves" (including the first in this series in the middle of 2013) are thus revealed as related to the whims of bank balance sheets.
What you can already sense is that none of these factors have anything to do with Dodd-Frank or Basel III, surely not directly, as is commonly discussed when in the very rare occasion some official is forced upon the subject (like the Treasury/Fed report for October 15). If it isn't regulatory factors or really "capital" considerations, then why are dealers so retreating, leaving the global "dollar" so drastically vulnerable at its classic chokepoints?
In answer to that, I can't help but think back to Alan Greenspan in June 2003. During that FOMC discussion he wondered, "one is that I don't think we know enough about how the private financial system works under these conditions." The "these conditions" Greenspan was spit balling was financialism near or at the zero lower bound (ZLB). What wasn't known then, and I'm afraid is still not appreciated even now after almost seven years of it (which these economists and their models projected as a total, complete and inarguable impossibility), was how money dealing and transmissions actually functioned with nominal rates and spreads compressed by the artificial weight of intervention and perceptions of intervention.
Ben Bernanke at that meeting was a bit more direct, though in his unequivocal support for why he thought QE would work despite no experience and very little aforethought: "...it [zero bound interest] works through mechanisms that depend on the imperfect substitutability of different assets". He was speaking about "portfolio effects" or getting banks to "invest" where policy wanted them in contradiction to where banks might want to avoid (which is why QE would be instituted), but nobody seems to have transposed that same through process to the rest of the bank portfolio including money dealing activities. The spreads on liquidity under a more "normal" interest rate regime are far different than those at the ZLB and further under the duress of multiple QE's (that strip usable collateral and leave money markets at the fate of their own "imperfect substitutability").
At this point you can really start to appreciate John Cryan's dilemma. When he suggests Deutsche Bank can't "afford" the capital luxury of its formerly all-important investment bank and derivative books, the very meat of eurodollar money dealing, he is speaking beyond just capital efficiency alone - he's talking about risk/reward. The last time banks were apparently quite open to expanding their "dollar" behavior was immediately following QE3 and QE4 in late 2012. It only lasted a few quarters until "taper" was uttered to the Wall Street Journal, and giving us another important clue in this detective work; profitability in money dealing was derived, if not from basic spreads, from the very expected influence of QE itself.
I have chronicled this point before, especially as viewed from interest rate swaps, so I'll only briefly recap that banks coming out of QE3 and QE4 were almost certainly betting on Bernanke at his word that those would be quite long-term if not semi-permanent. It seems, especially in this hindsight exposition, that was the last straw, last ditch effort for money dealing to take center stage upon bank considerations. Thus, taper was not just a betrayal of those expectations and the resources oriented one last time in that direction, it was the final move in the paradigm shift that started way back in the summer of 2007. If dealers could no longer make a reasonable and sustained money dealing profit from even QE's, there was nothing left to hold them to it.
In a vacuum, that would be quite a welcome development. If there is one thing the financialized global economy needs most it is to become far less financialized. The retreat of so much money-dealing and the debt that accompanies it should be the first goal of any attempt to reform (which, as more and more now seem to notice, especially off the Fed's own reluctance, is going to be the first necessity very soon). The problem is, obviously, that this is not what is taking place; every central bank around the world is still trying to rebuild their systems and the global economy (as it is inseparable) as if it were still 2005. More than that, because of the remaining, stubborn deference given to central banks and their assumed financial wizardry, many parts of the global economy are themselves yet allocating resources and positioning business for that very same goal.
Primary among them is China; or was. No individual national part of the globally financialized, eurodollar economy benefited more than the Chinese. The very Chinese "miracle" itself was nothing but an offshoot of global banking. Emerging markets like Brazil were similarly situated as the secondary beneficiaries of China's remarkable ability to deliver and service the financialized economy of the 2000's. Global trade was tied completely to this central eurodollar axis.
This was putting the cart before the horse. The eurodollar system was meant in its earliest days when Bretton Woods was collapsing (especially once the two-tiered gold price was established in 1968) as a liquidity mechanism to finance global trade exclusively. After Bretton Woods finally sailed into history in 1971, the eurodollar was already operating as that very means for trade finance. It was thought a superior framework to gold because it could be, as a credit-based reserve system, more responsive to the demands of trade concerns.
In other words, trade comes first; global eurodollars come after to meet that organic economic demand. The 2000's have it all reversed, as eurodollars and bank balance sheet expansion sought out exponential growth no matter what (that was, after all, the whole point of the housing bubble and the manufacture, from nothing, of financial collateral even in money dealing itself). Finance came first and trade built up around the bubbles around the world.
Under such financialized condition, there is little surprise the financialized economy cannot recover from the Great Recession; without the money dealing in eurodollars to support those past trends and resurrect activity to meet expectations for that, there is no pathway for the economy to actually mend. Central banks have been "stimulating" in the vain attempt to fill that gap with their version of "aggregate demand" but that finite effort (assuming there was anything positive gained at all) has finally appeared at or near its expiration - starting and most visibly through China.
As the Wall Street Journal reported this week, global trade projections have "unexpectedly" fallen off a cliff this year. With China screeching toward its own maladjusted ends and Brazil and many emerging markets in desperate trouble, this isn't much of a shock. What is less appreciated is that the origins of that despair are not just the "dollar" but the fact that developed "demand" is as much financialized. US exports have fallen throughout this year, but so, too, have US imports. The world keeps expecting "global growth" to bail everyone out of these deep economic holes and ruts, but instead:
"It's fairly obvious that we reached peak trade in 2007," said Scott Miller, trade expert at the Center for Strategic and International Studies, a Washington, D.C., think tank.
That would be, more specifically, August 2007. In chickening out yet again yesterday, the FOMC did exactly as I expected they would - not just in failing to raise the rate but in blaming "overseas" trouble and China for it. It allows them to suggest that they are blameless and that optimism is still reasonable at least inside the US (their point about "vulnerability" rather than outright worry). But in the sense of all these highly connected, intricate and esoteric wholesale dynamics, "overseas" problems are indistinguishable from our own.
In the end, that Deutsche Bank, as Credit Suisse and all the rest, continues to flounder in money dealing means it will further retreat from it. Without eurodollar extensions, the global dollar short is more than problematic - which means so, too, is the financialized economy still unfortunately tied to it. Janet Yellen just doesn't factor; the more banks lay off workers and restructure against their former eurodollar dealings, the more that will contribute a "rising dollar" disruption fostering "overseas" problems which will keep the Fed still further on hold. What is missing is that connection since there is no "ours" and "theirs." If the eurodollar decay is taking out China and Brazil, it has already weakened here. "Transitory" is the fantasy of where money dealing doesn't matter and central banks can keep overlooking what they really don't know.
