The Swiss Are Confirming Intensely Tight Markets

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If only there was a global savings glut. The term originated with Ben Bernanke in the middle 2000's as a means to express a partial guess about what was troubling Alan Greenspan at that time. He termed it a "conundrum" in that long-term interest rates were not following the Fed's emphasis in raising its federal funds target. All monetary theory to that point had more than suggested long-term rates existed as a function of some form of stacked premiums, and thus an increase in the shortest rate, taken as the risk-free, would move the entire curve in near-unison.

Instead, from 2004 onward, the yield curve sharply flattened under pressure from the FOMC in "tightening", and then inverted altogether. It was trading in eurodollars and eurodollar derivatives that should have provided Greenspan and Bernanke clues as to the nature of this policy rejection. Eurodollar futures, in particular, were trading dead set against monetary policy - the Fed was raising the federal funds target while the eurodollar futures curve, aided by swaps trading, went in the opposite direction. The loose dichotomy of the modern "dollar" was on full display.

Of course, by the middle of 2007 the positions reversed. Trading in eurodollar markets "tightened" though not through any actual policy direction. Risk premiums and calculations for expected volatility began to adjust in light of new perceptions about credit production gone insane in that era. The response of the Fed in September 2007 was to "loosen" policy, by 50 bps no less, which had exactly no direct effect. Eurodollar trading continued to the opposite right up until the failure of Lehman Brothers when "dollar" flow completely ceased.

The cliff that appeared in September 2008 was not really of American origin, as eurodollar "creation" was highly proportional to European banks. Some of the largest and most enthusiastic of participants were the Swiss. Most global banks, as a matter of prudent risk management, tended to run "matched books" especially where numerous, significant currency positions are evident. In the case of Swiss banks, there were heavy allocations to not just local francs (both assets and liabilities) but also euros and especially "dollars."

This increase in "dollar" exposure began around 1995, curiously (to anyone not familiar with the actual mechanics of the housing and dot-com bubbles), the exact same year housing construction broke free of historical activity and US stock valuations suddenly surged into a paradigm unseen since the late 1920's. While most people think of "money supply" in generic but local terms, the global exchange standard of the late 1960's onward meant that "dollars" weren't really dollars - and thus were most likely, especially in the late 1990's, to have almost exclusive foreign origin.

In August 1996, the Swiss banking system showed exposure, on both the asset and liability sides, again the "matched book" principles, to "dollars" of about 17% of their total cumulative balance sheet. By the time of the dot-com recession, which was characterized globally in both the global economy and eurodollar standard, Swiss exposure had almost doubled to more than a third of all allocations.

However, from about mid-2003 forward, right at the moment the FOMC was debating "ultra-low" interest rates as they had pushed their federal funds target down to a then-historic low of 1%, the Swiss suddenly departed from the "matched book" in "dollars." The largest of the Swiss banks began to "over-supply" eurodollar liquidity in relation to their liability structure. While we can never grasp full appreciation as to why the Swiss would suddenly depart from "prudent" balance sheet allocations, there can be no doubt that the "ultra-low" interest rates themselves played a role. From the perspective of the Swiss, they could supply all the "dollars" into the eurodollar market they wished with the convention of federal funds in NYC to act as "elasticity" should it be needed.

There was also the matter of self-fulfilling mechanics, as an ultra-low policy rate had the effect of influencing volatility calculations - banks believed that when the Fed was so "active" in "loose" policy (when in fact the Fed's balance sheet did exactly nothing during this period, credit creation and "money supply" is left totally to bank balance sheet expansion) there was little risk to asset price swings. This was something of an artifact of when money was money, or at least currency was something more than a ledger entry between European banks, but to many black box risk management "limitations" it signaled unequaled expansion.

So when the Fed tried to influence the "market" to tighten all they accomplished was increasing the apparent cost of "liquidity" in both domestic and foreign wholesale. For "liquidity" dealers the nominal cost wasn't nearly as important as the spreads in various liquidity-providing operations, such as eurodollar futures. Thus the eurodollar market could take on a life of its own almost fully independent of monetary policy influence - it expanded because it wanted to as there was so much "money" to be made in sheer volume. As the Swiss, and pretty much every other eurodollar participant including those on Wall Street, kept on providing greater "dollar" liquidity regardless of Greenspan's belated attention to credit production, policymakers in Washington became increasingly confused.

Much of that confusion stemmed from simple evolution of banking and global finance in the 1980's. It's not as if eurodollars were foreign to the FOMC, indeed there was much appreciation for eurodollars in the early 1970's, including the months preceding the end to the dollar's convertibility.

From the July 1971 FOMC meeting, the month just prior to the closing of the gold window:

The first of these, which was discussed at considerable length, concerned central bank swap transactions with their own commercial banks. The bulk of the swaps was accounted for by two countries, Japan and Italy; and it appeared that the volume outstanding might total $3 to $3-1/2 billion, or roughly as much as the volume of direct placements in the Euro-dollar market by central banks of the Group of Ten. The motivation for such swaps was not wholly clear, but apparently they were used as a means to affect domestic liquidity, to provide better financing terms to importers, and to improve the liquidity positions of commercial banks while leaving with them the burden of exchange risks.

That simply meant that by 1971 the eurodollar market had already begun to function as a gold exchange standard equivalent, the "means to affect domestic liquidity" in "dollars." This was a far more primitive arrangement, however, in that central banks were of central importance as a means to provide funding "flow." What took place afterward, slowly and apparently imperceptibly to the FOMC's various coming arrangements, was a bastardization of that "dollar" network for liquidity whereby wholesale funding almost totally replaced the traditional "reserve" framework of deposit liabilities.

The key ingredient in all of it was bank balance sheet mechanics, which, at some unknown point, far surpassed any central bank swap activity as the primary means to direct "global dollar flow." The second primary evolution involved the premise for these non-dollar "dollars" in the first place - in the 1960's and into 1970's their intent was to provide "dollar" liquidity in foreign trade replacing gold. Around 1995, a very important year in "money supply" evolution, there was a tremendous shift in the target for "dollar" activities. What once stayed almost exclusively a foreign affair, as if there were two "dollar" systems operating in parallel, one domestic and the other foreign for trade, began to commingle.

As noted above, that meant credit supply in the US was now open to very foreign influence, including this other "dollar" system. And the Swiss were right there at the forefront, leading to Wall Street's incessant demands to be freed from the regulatory strictures of Glass-Steagall so that they could "compete" with foreign banks in their own "dollar" terms.

The imbalanced book of the big Swiss banks, though, created an unappreciated precariousness as it amounted to a synthetic short position of "dollars" (which is over-simplifying here, as the Swiss banks have a "short" position in "dollars" even where liabilities overcompensate). Any kind of disruption to "dollar" flow would lead to a short squeeze of not just financial pain but actual illiquidity and even violent insolvency - like that which began on August 9, 2007. Rather than a "global savings glut" what developed was a eurodollar flow framework of evolved liquidity far different than anything that had existed even when eurodollars first emerged.

So as the FOMC began a course of "stimulus" throughout the latter months of 2007 and 2008, these "dollar" markets again did the opposite, tightening tremendously and causing no end of dangerous disorder throughout financial markets everywhere in the world. The Swiss matched book closed rapidly right in August 2007. The months immediately following Bear Stearns and then Lehman Brothers insolvency saw further hasty withdrawal of Swiss participation especially in interbank liquidity. At the start of April 2008, the Swiss system was providing CHF521 billion in "claims against banks"; by September that amount had decreased to CHF485 billion, only to collapse thereafter to a low of CHF259 billion by October 2009.

There was no amount of interest rate cuts to the federal funds target that could make up such a heavy disruption to "global dollar flow", and that was just the Swiss end of it. Indeed it ultimately took almost three-quarters of a trillion dollars in Federal Reserve swaps to other central banks to only slightly fill in that gap, and it only occurred long after the worst was actually over and trillions in losses on asset price declines taken.

Far from extinguishing the "global dollar short", the post-crisis era has only seen it transformed. For the Swiss' part, they have remained far more subdued in "dollar" participation in both liquidity and credit production. The matched book returned quickly, and has been overtaken by what really amounts to an over-collateralization between assets and liabilities; in other words, in the opposite position of the housing bubble, Swiss banks carry more dollar-denominated liabilities than assets. That is, by no means, a guarantee of total insurance against a repeat of the downside to their massive short, but it is at least far less of a risk.

At least that seemed to be the case prior to 2014. There wasn't so much dollar disruption apparent in the Swiss banking system even in the 2013 taper-driven credit selloff that extended to a lot of other eurodollar segments, notably emerging markets. But in the past few months, especially as the "dollar" has "risen" so dramatically, in a move that can only be compared with 2008, what looked to be a solid "dollar" position has grown far less so (at least as far as we can tell through October, the latest month the Swiss have provided banking statistics). If that is the case, that is trouble for Swiss banks again as it could mean that they will find themselves in the same predicament as eurodollar participants in emerging market nations already awash in related currency crises - especially Russia, Brazil and even China.

That is perhaps the most unexpected result of this recent turn toward "dollar" tightening and dramatic bearishness. Brazilian banks are almost perpetually short of "dollars" in these kinds of discrete breakouts of disorder, but you rarely think of the stodgy and staid Swiss banks as something similar. However, this shouldn't be a surprise since the SNB essentially guaranteed this outcome by pegging the franc to the euro in September 2011 (which was another eruption of a "dollar" crisis).

You can certainly understand the Swiss' predicament then and now. As thought of as a sound currency and a center of global "flow", the Swiss financial system is a nexus of various cross-currents, including the negative reactions to the persistent monetary madness of the ECB. In many ways, the franc acts as a shock absorber for whenever the ECB makes a major mistake, which is too frequent to operate fully sane policy in Switzerland. The Swiss economy, as such, is far too susceptible to these kinds of shocks, which, in terms of the euro peg, meant that the balance sheet of the Swiss National Bank would act as an almost last line of defense against lunacy (and, as we see now, almost complete ineffectiveness).

This is not to say the Swiss have been infallible, only that in relative comparison to almost everyone else there is almost prudence in their actions. But where they venture into dangerous territory is the same as where every other central bank foundation exists, namely in betting the house on monetarism. As with almost everything a central bank does, even the euro peg amounted to an "extend and pretend" type of policy only designed to buy time. It was never intended as a full measure of protection of semi-permanent stature. The Swiss believed, as did the European monetarists and the Japanese monetarists and the American monetarists, that the ECB's heavy-handed tactics would work.

The problem now in 2015 is that such faith in monetary policies is being disproven in no uncertain terms (and actually empirically). There is no recovery in Europe just as there hasn't been anywhere else since the global economy is exactly that. China continues to falter because "demand" in the US continues toward elongated attrition (which is a fully related topic to the eurodollar/bubble system). Europe is headed toward recession, making essentially a single seven-plus year depression while Japan has used "inflation" to all but destroy the very core of their own economy in a 25-year fit of the same.

Switzerland is thus susceptible again in the shifting perceptions about "dollar" conditions in global funding markets. The "rise" of the dollar in these terms is not about relative value or interest rate differentials, it is the cost of maintaining "dollar" liquidity via synthetic short. The dollar system that nearly failed in 2007 is evolving itself, but has yet to reach another such stable paradigm (which I don't believe anyone has any idea what form that might take when all is said and done, and it may be many years for that to happen including serial bubbles and crises as long as orthodox policies remain, ill-suited, in place) meaning the same "rules" mercilessly still apply.

For Switzerland that has pegged itself to the euro as a defensive measure, that has meant all the downsides of being on the "wrong" side of the short as the squeeze initiates and strengthens its ill-mannered grip. It was, in September 2011 for the SNB, a moment of pick-your-poison. They chose what they believed was the least worst option. As of yesterday, they no longer believe that to be the case.

In removing the floor to the franc against the euro, the SNB has unleashed tremendous counterforces. Stocks crashed, liquidity was gone and there were market disruptions all over the world. For the Swiss central bank to endure all of that showed exactly how concerned about the "dollar" flow they are by relative comparison - if they are willing, in this short-term, to accept the consequences of removing the peg, what does that say about what they believe as the consequences of keeping the status quo and taking on "dollar" problems? In fact, in announcing the move, the Swiss National Bank appealed directly to this "dollar" problem in its explanation:

"The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified."

It was and shall remain a "dollar" problem, not necessarily, as convention has it, that the ECB will do some kind of QE next week. The European QE only touches upon the primary Swiss problem in that it may make "dollar" participation that much more costly and difficult for Swiss banks, and so the SNB threw in the towel and decided to ditch the monetarism solidarity no matter the potential near-term costs.

In a larger sense, there may yet be an echo of the PBOC in this move. The SNB is taking a stand to more closely align the franc with the dollar as a byproduct of the eurodollar realities. That means potentially "deflation" upon the Swiss economy, very much like the PBOC has shifted far away from "inflation" as a means of "stimulus." This is almost an anti-Japanese attitude in that traditional monetary thought at a major central bank has shifted 180 degrees as a matter of no economic recovery (at least one that is beyond artificial and far too fleeting).

And that is the primary point to be pulled out of all this mess, in that the transitions in the eurodollar system (into it in the 1980's and 1990's, and then out of it post-2007) did nothing to enhance the state of the global economy, instead allowing and even nurturing these massive financial imbalances that remain as an anchor on economic livelihood the world over. What the eurodollar system essentially does is transmit contagion far and wide, assuring that major economic dysfunction never stays a local affair. That is exactly the argument that modern monetarists have made repeatedly and emphatically about the gold standard in the early 1930's; to which all this central bank "flexibility" was supposed to be a permanent cure.

The Swiss have simply confirmed what many outside orthodox monetarism already have suspected, that markets, especially global funding markets, are tightening in intense fashion. Such a factor is never directly observable due to the means of actual bank balance sheet operations mostly taking place far from broad view, thus, like 2007 and 2008, "dollar" disruption is detected only indirectly and almost always after the fact. The end of the Swiss currency peg is but another indirect commentary on the growing negative state of the "dollar" world. In relative terms, these central and vital "markets" are projecting greater and greater probabilities of desperate trouble ahead, so much so that it has central banks choosing again what they hope are the least worst options.


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

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