Will Markets Wake Up to the Folly of Monetary Intervention?

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Since the panic days just after Lehman Brothers in September 2008 through September 2011, the Swiss franc had gained almost a third compared to the euro. It was an epic move that had gained steam in mid-2011 as the renewed crisis over Greece and the PIIGS threatened further instability in the Eurozone. Money in various forms was leaving the unstable domicile of European periphery nations for the steady, stable handle of francs. All throughout last summer the Swiss National Bank (SNB), Switzerland's central bank, hinted and rumored of pegging the franc to the euro to stem the flood of money. The soft attempts at persuading the market to do its bidding, to achieve an effect without ever having to commit resources, were, unsurprisingly given the scale of the unfolding drama, unsuccessful. On September 6, 2011, however, the SNB unleashed FX fury, pegging the franc to 1.20 euros and pledging to defend that level no matter the costs.

Immediately, the franc lost about 8% against the euro, a stunning move in cross-currency trading that caught many traders and institutions off-guard. It was conventional wisdom at the time that the SNB would never go so far, so betting against the peg was rather uncontroversial - there was no way that the Swiss would willingly risk potentially unlimited losses on a euro that seemed destined for the trash pile.

In the monetary game of chicken, it seems unwise to bet against a central bank's resolve to maintain its own sense of order. Sure the Swiss economy is export-oriented, but it is the denomination of assets and liabilities within its mammoth commercial banks that would bear the brunt of currency "flight" into the country. It would be borderline suicide to let the franc rise to a point that an imbalance in currency mismatch at the bank level would mean effective insolvency - especially when those banks collectively dwarf the country's relatively modest GDP. As we have seen time and again since Lehman, banks are defended at all costs (and that defense is dressed up in the cover of protecting the real economy).

Given that resolve to defend these massive (and still imbalanced) banks, the hints and rumors that come from central banks with regard to maintaining imbalances in their own banks (all in the name of maintaining "normal" functioning) go beyond simple attempts at moral suasion. Of course it would be beneficial (from the perspective of a central banker) for markets to carry out monetary policies without direct involvement, but markets in these times of unending turmoil often seem impervious to ephemeral inveigling.

The Swiss franc is again at the forefront this past month in a couple of attempts to breach the 1.20 peg (none of which have been successful). In a more worrisome sign, however, Swiss government bonds are accelerating into negative yields, highly suggestive of a "flight to safety" that is working around the franc/euro peg. In early April 2011, just as the previous iteration of crisis (not coincidentally, the monetary intervention blackout that began around the end of QE 2.0) began to filter into wider consciousness, the 2-year Swiss government bond was yielding about 80bp (0.80%). By August of that year, that yield had dropped to 0bp, oscillating between slightly positive and negative yields. That range (mostly with a slightly positive yield) held until April 2012. Since May 23, however, the yield has taken a nosedive below -25bp.

Around the same time we have seen a marked decline in bond yields of "safe" issuers, including German 2-year bunds hitting 0bp yesterday for the first time in history (for comparison, the German 2-year bund yielded 1.67% on July 4, 2011). All around the world, including here in the US, "safe" bonds and their yield curves are flattening dramatically.

This all suggests a serious liquidity problem (again!) in the global banking system. It is taken on faith that these yield movements are due to money moving away from "risk" to the "safety" of high quality government bonds, but the far more important aspect here is that acceptable repo collateral has once again become very strained. Negative yields on government bonds is not so much a statement about how investors are willing to pay for the privilege of parking their money safely (at two years, no less) and more about financial institutions in such a liquidity bind that they are forced to pay a penalty to obtain operational liquidity (since rehypothecation is still a possibility here, the penalty is more easily absorbed by this "efficient" use of collateral). Negative government bond rates is a definite signal that all is not well in the land of interbank repo.

This correlates well with the decline in prices of Spanish and Italian debt now that the LTRO's are no longer viewed as definitive saviors (it didn't last very long, less than four months from the first LTRO until the credit markets reverted back to almost total dysfunction), meaning that repo funding will get tighter in those names (as haircuts get adjusted back to this pricing reality rather than the pricing of hope regime that each intervention represents), forcing institutions to scramble to lock up the last vestiges of "quality" financial pieces before none are left and only a mortal trip to the discount window remains. That this almost inevitable cascade is now playing out as far down the yield curve as two years is really a testament, I believe, to just how little collateral remains unencumbered in Europe.

This liquidity desert is a bit different in 2012 than 2011 (or even 2008), however, since there is now the element and specter of retail deposit movement. There is no doubt that the bulk of liquidity problems in the affected countries is being caused by foreign investment flowing out, but there has always been, especially in the case of Greece, at least a small element of retail deposit flight. It appears as if that steady but as yet slow drain of retail money out of the periphery has picked up steam. That represents a sea change in this crisis, which has been, up until recently, almost exclusively a bank run from banks themselves. The lack of liquidity has largely been a function of broken interbank markets and institutional unease with counterparties and their posted collateral rather than general and unabashed fear in the larger public.

If that trend continues to grow, particularly as the threat of currency chaos is unchecked by a lack of serious solutions to the massive monetary imbalances embedded within the euro's own schematic, that represents, obviously, the biggest danger to the system yet - even bigger than 2008. There is a world of difference between a bank panic solely amongst banks (which caused all manner of havoc in 2008, and nearly again in December 2011) and a full-blown, full-scale bank run of retail depositors. Even a partial and amorphous bank run could be devastating, given the lack of alternate funding in the marketplace. Deposits are considered (read: modeled) to be a very stable source of funding - changing that assumption quite possibly changes the liquidity profile of large swaths of the global system, not least in their own calculations of their own liquidity needs.

There is a growing unease in the deposit base that did not exist in previous episodes of this largely uninterrupted financial crisis. As I pointed out a few weeks ago, one of the changes in the global banking system as it adapted to the interbank model, especially centered in London around eurodollars, was the "hub and spoke" model to these global bank institutions. The premise of the hub and spoke is to gather local deposits in local currencies and then swap them for dollars to participate in the dollar asset market - the most liquid and most sophisticated, run "efficiently" by Wall Street in collaboration with London. That swap of dollars created a massive shortage or overhang of US dollars (figments of a bookkeeper's pen) that was at the very heart of the 2008 panic.

The dollar shortage has not been erased in the months since Autumn 2008, and no one yet has a good handle on just how big that shortage is (given the massive growth in interest rate swap derivatives in 2011, it is highly conceivable that the dollar overhang has actually grown larger). It was little surprise that the Federal Reserve's dollar swap lines were re-activated in September 2011, at OIS + 100bp. What was a little shocking was that at that rate no bank, not one, activated its usage. It was not until the premium was cut in half on December 8, 2011, to OIS + 50bp that dollars started to again flow into Europe. That suggested that the state of the European banking system, through its eurodollar overhang, was in such a precarious state that it could not pay a 100bp premium (which was not all that expensive).

Before the change in swap premium, there was $0 swapped out at the Federal Reserve. After that change, usage quickly grew to $100 billion in a matter of four weeks. It was a mark of desperation that had been unseen since 2008.

In the scheme of the hub and spoke, any trouble in obtaining US dollars for short-term funding of all this eurodollar activity can usually be "covered" by an increase in home country deposits. Those additional deposits get swapped into dollars through a euro/US dollar basis swap (increasing the potential dollar overhang, but at least temporarily contributing to dollar liquidity). What happens, however, if the market for home country deposits is not as robust?

That is the trillion dollar question for this summer. The dollar crisis of 2008 has already infected the euro, with euro area liquidity now as bad as dollar liquidity ever was - and the acceptable list of collateral (outside of central bank discount window equivalent schemes) in any denomination pared back to a few sovereign names. Given the potential for a dual-action dollar/euro liquidity event, the stress level rises that much further. At each of these kind of stress intervals, the game changes dramatically. Banks no longer look for just marginal liquidity, they begin to become true hoarders. At that point the flow of money transforms and mutates, and the only liquidity answer is a radically altered monetary response or just outright firesales.

We know what firesales look like, having seen a relatively big one in 2008, and two smaller episodes in May 2010 and July/August 2011. I think it is not at all surprising, given the seriousness of money attempting to flee to Switzerland recently, that Thomas Jordan, President of the SNB, introduced the dreaded idea of capital controls in a very public manner. How much was this just cajoling the markets, since it was clearly aimed directly at the euro capital holders, and how much was a potential warning of a rerun of the franc/euro peg?

The element of retail deposit flight is the match in the dry tinder of the European banking system. At some point a policy response like this, instead of calming the unease plaguing the system, actually sets off a chain reaction of crisis. In the case of capital controls, it gives retail depositors every incentive to flee now and not wait to see if that window is shut, trapping money and savings in a ruinous bank or even being forcibly converted into an unwanted devaluing currency. I think Mr. Jordan and the SNB is very aware of that possibility, yet it was extolled in the media anyway.

Policymakers have been behind the curve at every step of the way: QE depleting the banking system of t-bill collateral for dollar repos; the dollar swap lines at an ineffectively high premium; does anyone even remember the EFSF that was the "final" solution; etc. The element of retail flight, and the potential seriousness expressed in Switzerland, all coupled with credit market activity of late, points to something very serious afoot. This has gone beyond simply policymakers failing to fix problems still leftover from 2008. We are now seeing the crisis move out of the financial system into the real world of currency and deposits, at exactly the most inopportune time. Maybe the markets can shrug off and celebrate $100 billion of dollar swaps at the Fed, but what if it becomes $1 trillion? Or more.

At what level of dysfunction do markets finally stop believing in the hope/hype of monetary interventions? At some point, markets will begin to see through the charade of these ineffectual solutions to the real problem: that the world, both the financial and real, has yet to resolve the imbalance of monetary printing from the artificial growth period of the Great "Moderation" (and even before). The true problem today is that prices are not reflective of that reality. The Great Adjustment has yet to be applied, and the more policymakers fight to keep that adjustment process at bay, the more tightly wound the system becomes, breaking loose in unintended ways that involve larger and larger segments of the system.

Tracing the "evolution" of this monetary/financial crisis, what started out as pricing problems in subprime US mortgages is now involving potential retail bank runs (1930's style) in several European countries to the point that a major global banking center is hinting at very real capital controls. There is a direct line between these events, spanning now several continents (as China falls into the abyss) and years, and no matter what emergency policies have been proffered and effected, that line has remained unbroken. At some point people all over the world will have to realize that this great imbalance simply cannot be fixed by money.

In many ways, that realization has already crept in - thus the market dysfunction. But, as the rallies around the LTRO's demonstrated, there is still significant faith in all things monetary. As the system winds tighter, locked in a critical state that is denied its needed phase shift, faith may become a luxury that comes with far too high a price. The Swiss may threaten to close the monetary border with Spain or Greece or Italy, but with each of these policy failures fewer will choose the faith option and deny themselves the chance to avoid the worst. Eventually there is just a rush as the herd finally awakens to the very scary, but all too real, probabilities that central banks will never find that magic monetary bullet. Financial gravity may be too strong a force to resist, no matter how much money an institution can print.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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