The Fate of the Fed's Exit Strategy Is In Foreign Hands

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In all this talk about whether the economy will be strong enough to support the first policy change of this cycle, and how utterly sad it is to even have to argue about it, the larger issues about the exact operational framework remain largely unexamined. The intent of the FOMC is to undergo an orderly transition from extraordinary policy positions toward a setting more like normal. To go from A to B is not as simple as plugging in a new number, a fact that Federal Reserve officials are very quietly dealing with. The Fed has a repo problem, one that has been around since August 2007, which only more recently has that been recognized; and even then only somewhat. From that are spun off simultaneous and related cracks.

There is much to be done to clean up the last crisis, undoubtedly, and there are some intentions to actually try. Just recently Sens. Warren (D-Mass) and Vitter (R-LA) proposed the Bailout Prevention Act that will "halt megabank bailouts during a financial crisis by responsibly limiting the Federal Reserve's lending authority. It would also close a loophole that creates risk-taking exemptions for megabanks Goldman Sachs and Morgan Stanley." This is undoubtedly a fertile subject that deserves the attention, but in many and likely more important ways this is facing in the wrong direction.

It's not enough to simply look upon "too big to fail" as a structural issue but rather why it became a structural issue in the first place. It certainly wasn't the Fed's crisis activities and emergency policies that created these megabanks, as the loophole isn't necessarily Goldman Sachs and Morgan Stanley but the modern state of the "dollar." The word "eurodollar" never much appears in even the Fed's own statements, let alone any political endeavors that proclaim to seek out structural inequities.

That is indeed a curious omission as the current period, which really dates back to the middle of 2013 when then-Chairman Ben Bernanke first unleashed the idea of just tapering QE, has become notable again for a geographic divide which bears some resemblance to the summer of 2011 if not that of 2007. The FOMC says it wants to raise rates, and to do so it will rely on several tools around which the central focus remains the federal funds target. But LIBOR has already beaten them to it, and it doesn't appear as if that has anything to do with the FOMC's on again/off again "normalizing" fantasies.

You can look at any number of interbank rates and measures and find just this sort of rising risk perception. From the TED spread to term LIBOR rates, about the only interbank rate that isn't participating is the effective federal funds rate (EFF), the very rate at which monetary policy is supposed to be carried out. It still seems to be rather conventional thinking that the FOMC decides to "increase interest rates" and by decree it is just done. There is enormous intricacy and importance in exactly how that happens, or, as the case may be, doesn't happen.

We can see the overall contours of the liquidity obstruction in that there is so very little volume in the federal funds market that it is practically and purposefully dead. It is, then, exceedingly odd that the Federal Reserve itself would rely upon a dead market in which to project its full weight of policy intentions. Furthermore, that weight of movement is carried out and back by the quantity of bank "reserves" which are more or less idle and ultimately (for most affirmative liquidity purposes) meaningless. The full count of these bank "reserves" were created as nothing more than a byproduct of the QE's, all four of them.

Again, convention still seems to hold where these "reserves" play some positive role in "inflation" expectations if not liquidity itself. There is, with the CPI having turned negative recently, a rarity that spans more than a half century outside the Great Recession itself, only some indirect validity in the former and some very arguable problems with the latter. In terms of actual economic transmission and loan creation, reserves bear little resemblance to either as bank balance sheets do not operate overall with them much in mind. That is where those predicting "runaway" inflation were always behind-the-curve as it is the deeper financial factors of bank balance sheet mechanics that dictate how and when the "money supply" moves and to what extent or purpose.

As far as liquidity, QE somehow maintains the illusion of raw "money printing." It seems unfathomable that the addition of almost $3 trillion in bank reserves could not be anything but the height of global liquidity, and that is what the Fed wishes everyone to believe, but the truth of the matter is much more complex. There is a very good argument, and one that LIBOR suggests, that QE has actually the opposite effect upon liquidity and that tightening monetary policy at such a juncture amounts to financial suicide - perhaps it would be better to put the Warren-Vitter bill up for debate sooner rather than later. We know as of this week that the Fed is taking that under advisement as well, having referred to recent UST volatility explicitly in these terms (though, comically but appropriately given their history, only counting HFT and bond funds as potential sources).

The same case can be made for QE as an economic depressant, as well, especially given the growing struggles of the economy in 2015 which already includes what looks very much like a consumer recession. But since the economics always get the front seat it is just as important, as I stated at the outset, to peer inside the opacity and complexity of the financial ends. To start requires looking back to the history of the Fed's "exit" plan, especially the events of last summer.

If you review the FOMC's policy meeting minutes for the July meeting, it is clear in all the "exit" talk that the FOMC members have not just a repo problem but a reverse repo problem (RRP) as well. They created the RRP as recognition largely of the dead market for federal funds, realizing that the "old" way of conducting monetary policy was no longer feasible as it had been in 2004 (which this discussion shows, to a great extent, why it wasn't really feasible in 2004 either; thus why the enormous financial imbalances and bubbles continued well past the point of Alan Greenspan's generosity). The RRP reverses the roles of the traditional open market setup, instead having the Fed "borrow" cash from the market collateralized with its now-enormous SOMA holdings of UST securities.

It is mostly forgotten, if it ever was appreciated in the first place, that the Fed in the middle of September 2008 conducted exactly this kind of program amidst the first stages of absolute bank panic (among only banks, as it were). The intent then was as now, because the federal funds rate, then with at least some good volume but for the wrong reasons, required, in the FOMC's view, being pushed up. As had occurred on several sustained occasions during the panic period, the effective federal funds rate was severely depressed below the FOMC's target rate. That was a problem for monetary signaling, as it was an obvious sign of distress, but also in practical terms as it meant this geographical divide.

While the effective federal funds below target meant a "surplus" of cash floating around domestically (which wasn't even as generic as that sounds) that was in sharp contrast to LIBOR which had first opened up an unusual premium as far back as August 2007. That premium took a dangerous turn and then surged in September 2008 while the federal funds rate sank; no "cash" in the eurodollar market, but an "oversupply" in federal funds. The purpose of the RRP's in 2008 was to "soak up" some of that excess domestic cash, hopefully pushing the federal funds rate back up to the target (which was not zero yet) while also providing at least a marginal collateral stream into repo operations, which were almost totally inoperable after Lehman.

Of course, none of that actually worked and for reasons that should have been obvious then as now. Prior to the actual panic, there were no palpable cracks at the geographical seams of the "dollar" market because everything seemed to flow without any distinction. That was the primary source of the housing bubble itself, namely that offshore bank balance sheets were creating "dollars" and having them flow onto our shores through the legal and accounting provisions that don't distinguish between eurodollars and dollars. The scale of eurodollar growth was so enormous as to be, still, unknowable.

What that meant in 2008 was that the "market" means for ensuring seamless dollar/eurodollar function had broken down, and if the Fed meant to fulfill its roles then it had to find a solution to the interbank divide. It did, but only well after the worst had happened, opening unlimited "dollar" swap lines with foreign central banks, to which they took out almost $600 billion at the apex of the illiquidity desert. Like an incomplete electrical circuit, the drawback of funding from London eurodollars was partially "soaked up" by the Fed and then only later and too late repurposed back into the market for eurodollars.

But just as there was no closed "circuit" for unsecured interbank lending, there was none for the secured option either. With collateral chains in full retreat, the Fed's rather de minimus RRP's were a drop in the bucket - the week prior to Lehman's failure the Fed reported only $54 billion in UST repo fails (combined "to receive" plus "to deliver"); the week immediately after, $3.5 trillion; by the end of the first wave of panic, $5.3 trillion. Not only had the eurodollar market ceased to be functioning, repo markets were also unworkable leaving very little left to hold up the entire weight of global finance.

In light of that, the FOMC wishes to try to get it right this time and has paid more attention to repo despite its stubborn adherence to the dead market federal funds rate. But in that July 2014 meeting, committee members expressed what almost comes across from the sanitary wording as disdain. "Participants generally agreed that the ON RRP facility should be only as large as needed for effective monetary policy implementation and should be phased out when it is no longer needed for that purpose."

That was an odd initial view because testing in RRP's throughout led to a rather uncomfortable conclusion, that in order to "assure" (to the academic models, at least) an orderly exit from ZIRP the FOMC would have to double the level of the first scale of tests. As it was, concerns for "over-reliance" on the RRP forced the Fed to then reconsider last September, coming up with instead a daily cap of $300 billion. They apparently needed the RRP's but the very use of them was itself an element of potential disorder. Even now, there is no clear idea about how the RRP's might function, with discussions at the April 2015 FOMC meeting moving toward a consensus where the RRP's might have to be completely uncapped during the actual exit attempt. They hate it but they can't live without it, a microcosm of the state of global liquidity as monetary officials try to sort out their rocks from their hard places.

The Fed has also undertaken three separate tests for its Term Deposit Facility, which acts much like the ECB's deposit account. And while all these tests have been reported as being favorable, it is clear by the confusion more recently about the very means to carry out their intentions (maybe) that they really have no idea what they are doing. That makes the LIBOR rate all the more potentially troubling.

So far, I haven't described much by way of figuring out how the federal funds market came to be so dead. Earlier this week on Tuesday, the effective federal funds rate actually changed for the first time in over a month (apart from month-end), falling 1 basis point to 12 basis points. From July 2014 through October 2014, you could have forecast 9 bps for the rate and only been wrong on a few occasions. What is missing is any real volume, as all that is indicated by the effective rate is what banks might lend if there was any demand for unsecured interbank lending domestically.

That demand used to be almost exclusively the realm of European banks. At the end of the second quarter of 2007, these European banks were raising daily $400 billion in federal funds and transferring that from their US subs to their foreign eurodollar offices (home or eurodollar subs). In other words, US banks were acting as one huge conduit of dollars into eurodollars, which puts much more perspective on the geographic divide as it grew toward ultimate failure in 2008; and why the Fed failed so spectacularly only accounting for the domestic end for too long.

By the middle of 2013 and the taper drama, the liability chain had entirely reversed, as European banks were now "supplying" $500 billion back into the US from eurodollars. This shift from federal funds assets to broad domestic dollar liabilities can be confusing, but it is utterly important to clear up where we are now:

"So in addition to dollar swaps, the Fed engaged in QE which was dominated by foreign participants. But QE from a foreign bank is not really possible since the Fed only deals with NYC banks - which include at least their NYC subs (of the largest banks, anyway).

"So to get these now-illiquid dollar-denominated assets off their books (mostly MBS), foreign banks had to transfer them to NYC, thus "paying back" "dollar" loans originated from their funding in domestic markets. Instead of a dollar loan to their home office, the foreign sub now engaged in QE purchases is instead credited in their "reserve" account with the Fed - the asset side changes from a loan to the home office to a cash reserve balance."

In short, QE killed the federal funds market which had already been deeply wounded by the crisis. Along with any change in structure there is likely to be a shift in character. There are indications that the global "dollar" market has taken on a new form in light of that breakdown in actual and once vital flow.

US banks have largely retreated from being "money market" lenders as a consequence of all of these confluent trends. Instead, European banks act as the largest proportion of "dollar" lending inside and obviously outside the US; in domestic dollars and in eurodollars. That shrinkage of liquidity capacity is quite troubling as it suggests inflexibility with regard to any strain. Indeed, we have already seen two immense episodes in that manner, October 15 and the Swiss "dollar" problem of January 15, and neither of those occurred under anything but more broadly benign conditions. And so LIBOR is on the move again.

The global liquidity system sounds like a unified vessel into which all "dollars" can be poured and shared, but the truth is there is a great deal of ad hoc nature to it, and in plain terms there are obvious divisions (and really divisions within division, for who knows how far stratification within the eurodollar market itself might penetrate; big banks vs. small banks, and by country and relative function, etc.). For all the planning and lessons we are told monetary policymakers say they learned in the years since, it is abundantly clear that was all just noise. The FOMC, confused as always, is still committing the same error by viewing global liquidity as a whole rather than itself in a much more robust role of guaranteeing channels through all these parts. What rising LIBOR suggests, especially at further maturities, is that the old compartmentalization that was supposed to be washed away in the flood of QE's was only temporarily dormant - and that what is left is but a fraction of former liquidity capacity.

Maybe that was to be expected regardless of what the Fed did, does or does not do. From a great many other indications, the eurodollar standard itself is increasingly looking to be on its last legs. August 2007 was the absolute apex in its construction and operation which, given the massive asset bubbles it engineered, may be a good thing in the long run that it fades out. The problem is that nothing so central to global financial operation can simply transform from one arrangement to the next without much discord. So we have the prospects for winding down eurodollar performance and at the very same moment the Fed here and there proclaims its wishes to end ZIRP; and so LIBOR is on the move again.

I personally find it very fitting that the FOMC will stick with the federal funds rate as its main expression of policy, or, as they put it back in July 2014, "it would be appropriate to retain the federal funds rate as the key policy rate." As I said earlier this week in describing it more accurately, it is "a process of fake reserves threatening highly indirect action in a market that nobody participates in." In this era of almost total monetary confusion from the top, the idea that the federal funds rate is "key" to anything can only make sense to the same policy apparatus that brought us the Great Recession in the first place and has now presided over zero recovery.

And that is why Warren-Vitter and so many other political interventions are misguided if somewhat well-intentioned. The problem is not so much Morgan Stanley and Goldman Sachs, or JP Morgan and Deutsche Bank, but of wholesale finance and the entire monetary paradigm that purposefully excludes money. Without a proper monetary anchor, the dollar has become a twisted agent of wholesale nothingness, into which not even those charged with defending and regulating it have much if any idea about what it is and how it actually works. How is it that European banks, and now a great deal of Asian banks, can create and "supply" "dollars" to banks within the US and to the rest of the world totally on their own?

The fate of the Fed's very own exit strategy is almost completely in the hands of foreign banks and their willingness to further supply "dollar" flow to even US counterparts. It is an ironic upending of the panic paradigm, as the only real source of liquidity ability is the very place where crisis the last time began. And I think that is the central point of LIBOR rising in 2015, especially after December 1 last year (ask the Russians and Swiss about "dollar" liquidity in the first weeks of last December), that in this skeleton process there is just nothing else left. Federal funds is dead and repo can barely absorb an increase without devolving to a heap of fails and disrepute. The Fed hung the eurodollar market out to dry in 2008, and now that is all that is left as they try to pretend everything is back to what it was. LIBOR's uptrend is gentle now, but it still puts emphasis on the fact of what little has changed and how much needs to be.


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

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