The 'Dollar' Is Dying In 2015, No Matter What the Fed Does

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October 23, 2008, was an unusual day in credit markets even within a vast sea of unusual days. Credit and "exotics" desks at banks were left scrambling to figure out how it was possible that the 30-year swap rate could trade less than the 30-year treasury. It was thought one of those immutable laws of finance that no such might occur, to the point there were stories (apocryphal or not, the tale is about the scale of disbelief) that some trading machines were never programmed to accept a negative swap spread input. The surface tension about such things was decoded under the typical generalities that stand for analysis; if the 30-year swap spread was negative that might suggest the "market" thinking about a bankrupt US government.

That was the basis for convention about the positive spread to begin with, as quoting fixed on a swap meant counterparty risk where the US government supposedly has none (or credit risk). To see the swap rate trade below its equivalent UST was akin to holy financial blasphemy; it triggered an unending stream of confused consciousness that groped for some kind of window back to the safe reality that had once, seemingly long ago by that point, existed. A very big clue would surface just the next day, as stock markets all over the world crashed yet again on October 24. The S&P 500 was down more than 3.5%, with the DJIA off more than 500 points at the low. The NASDAQ would finish that week off just about 10%, making it -30% for the month of October.

Interest rate swaps are, obviously, a derivative instrument whose reason for existence isn't entirely clear to even erstwhile financial industry professionals; they are a total mystery to almost every economist including and especially those that claim to control the economy through financial means. By and large, the fixed side of swaps is taken by those on the "buy side", such as pension funds and insurance companies, that are intent on controlling risk factors such as duration and interest rate volatility (expected, of course). Writing these swaps were also insurance companies but more of the variety of AIG, but also the "money dealing" banks.

So you can begin to fill out the broad picture as October 2008 wore on, even though the worst of the broader market panic seemed to have been left behind. The demand for fixed side hedging was only increasing as the money dealers were both withdrawing and being unwritten in their assumed steadiness (not just ratings downgrades but very visible capital deficiencies and worse in terms of extrapolations at that moment). It was in every sense a rerun of the credit default swap reversal that had nearly brought it all down in March 2008 and then again with Lehman, Wachovia and, of course, AIG that September. In short, the "buy side" was in desperation for more hedging lest their portfolios and leverage employments tend too far uncovered while the dealers were in no position to supply it; desperate demand and no supply means prices adjust quite severely, which in this case pushed the swap rate, the quoted fixed part, below the UST rate for the first time ever (not that the swap rate history was all that long by then).

Well after all seemed to have normalized within the ashes of near-ruin, a panic that the FOMC believed less than impossible largely because of its own disastrous self-appraisal emanating from the dot-com bust, it started again. In March 2010, now the 10-year swap rate traded below the 10-year UST. This was closing in on the published end of QE1, but the world was declared normalized even though the 30-year swap spread never did - it would actually remain negative until 2013!

On March 23, 2010 Bloomberg tried to explain the 10-year's noncompliance with the recovery narrative by suggesting it was too much demand for higher yielding corporate and EM debt. They quoted the duly-selected "interest rate strategist" at a big bank to say that, "It's hedge-related activity related to new corporate issuance." Of course, there were other more nefarious explanations too, even visible and outright close to the end of that March - Greece. Lost in the shuffle of eurodollar dollars is often how much European banks were often the primary suppliers of wholesale funding, including this dark leverage that all these derivatives apply in confusing and typically-unseen fashion.

Only five weeks later, the US market would again crash, even if it recovered that same day. The S&P 500 hit a recovery-leg high of 1211.67 on April 15, 2010, and then proceeded alarmingly lower, including the flash crash of May 6, to lose 15.6% to July 2, 2010. You can start to see the pattern here between "dollar" liquidity as marked in the bowels of dark leverage and the actions in the outer reaches of asset markets including US stocks.

In fact, US stocks would not seriously recover from that 2010 "unexpected" setback until August 27 and Ben Bernanke's appearance at the Kansas City Fed's Jackson Hole outing. There, infamously, he whispered about a second dose of QE which would not actually be launched until that November, but which "markets" of that time did not care of details. The 10-year swap spread did not cease being negative with Bernanke's outed plan, but its frequency below zero did lessen. That juxtaposition perhaps suggests the great balance of the "recovery" age, namely that QE had some effect on something, but it's not altogether clear exactly what that was or even why.

The manufacturing byproduct of quantitative easing was bank reserves, which everyone just assumed (and far, far too many still do) was money. More money equals, in this view, more liquidity and thus all the positive financial attributes which are assumed the only necessary conditions for economic recovery. In the orthodox view, marginal economic growth is to be debt-based or nothing, so the assumptions about QE's inner workings looked fitting.

Global "dollar" liquidity, however, receives very little bearing from bank reserves as you can surmise from intuitive sense about the continued state of dark leverage during and after the panics (there were several) starting August 2007. Despite repeated QE's, swap spreads and global "dollar" circulation, as a matter of bank balance sheet formulation (the real printing press), stubbornly refused the broad invitation that was enthusiastically accepted by other asset classes. It is often thought in the conventional view that the financial system is a unified whole, but the truth of the matter is much more complex including very separate spaces for diverging functions. The fact that dark leverage sat upon the sidelines while stock prices surged was not surprising at all, but so too is the opposite where a heavy strain in dark leverage can overwhelm any marginal stock regime to the great downside.

The 10-year swap spread would see negative here and there throughout the next few years, again suggesting far from normalization, but would do so once more on September 20, 2012. That date comes one week after Ben Bernanke makes yet another appearance in our historical recounting, this time for a third round of quantitative easing (which you might get the feeling the first two were at least somewhat ineffective). That was announced on September 13, where the swap spread was a positive 7 bps. That 10 bps swing sounds like almost nothing, a rounding error or inconsequential flutter of typical market variation, but this was the world of ZIRP and QE's. When the 30-year spread fell negative for the first time in 2008, it had fallen more than 50 bps to do so over that panicked few months.

This was a far different world in 2012, though, and the negative 10-year spread suggested something different itself not quite apparent on the surface. QE3, as opposed to the separate and distinct QE4 of December 2012, was MBS but not purely as purchasing packaged mortgage loans. QE on the MBS side works through production coupons in the TBA market , a manner of pre-packaging loans within the pipeline process. When QE3 was first announced, production coupon spreads rose as was intended (it is the rise in production coupons that is supposed to entice more MBS volume). There were also effects upon "dollar rolls" (more derivatives, why not?), which seek to mitigate the dynamic relationship of the mortgage pipeline to the pricing of the production coupons (locking in of spreads and such).

Skipping a lot of complications, the effect of QE3 as it related to swap spreads was seemingly the reverse of the prior two episodes; banks, dealer banks in particular, were actually opening up their dark leverage to additional volume, so it seemed. While there was likely some extra demand for hedging from new expected MBS volume, it is also clear that there was a surplus of "supply" this time as opposed to the prior illiquid periods. In general terms, dealer banks seemed especially willing to write the floating side of IR swaps.

The reason for that becomes clearer in following along with what happened only a few months later. It isn't obvious or even anything more than conjecture in hindsight what the actual catalyst was, but in early February 2013 swap spreads turned suddenly and sharply higher. Again, conventional commentary read that as normalization but straight away there were indications that just was not the case. By mid-March, repo rates were seriously negative, with far-too-prevalent specials, with a sharp and sudden surge in repo fails the week of March 13, 2013. As always, conventional commentary was sure that was normalization, this time UST "shorts" (betting on rising interest rates in the great recovery that was "certain" to shortly follow) overwhelming a tightened repo collateral supply threatened by the presence of QE4 buying in on-the-run UST.

There was also the collapse in gold prices which was, yet again, proof positive of the great normalization, Bernanke's conquering of the "pessimism bubble" and finally restoring both financial health and surely the full weight of American economic growth.

In the wholesale view of the eurodollar standard, however, these were all warnings of a different type than those of 2007 and 2008 (even 2010 and 2011). It wasn't just collateral shortage as both repo fails and gold were telling; this was something far deeper. That would become apparent by May 2013 when the credit and funding markets were shaken yet again by an "unexpected" storm. The FOMC members declared over and over that "taper wasn't tightening", and indeed they hadn't even tapered anything yet but were only suggesting it, but the MBS market in particular was marked for a rout that would crescendo on June 24.

It wasn't just fixed income in the US, of course, as this violent financial episode rocked foreign currencies into sudden and, as always, "unexpected" crisis. They were scant clues about what was going on, but there were enough to figure out the usual eurodollar pathology even if in different format this time.

For starters, the TIC figures showed a massive bout of US asset "selling" in June 2013 - right at the moment of highest MBS and fixed income/funding pressure. At almost -$80 billion, it was the highest negative "dollar" figure in the series, a huge "dollar" warning. Reading TIC from the wholesale perspective is a little different than simply digesting buying or selling US assets, as what "selling" amounts to is foreign attempts to supply "dollars" in immediate (read: emergency) fashion because of lost funding from regular private rolls. In fact, on the private side (TIC includes "dollar" activities on both private and official accounts) there was "selling" of US assets for four months running - dating back to March 2013. The amounts for both May and June 2013 were staggering, totaling together more than $120 billion.

From that we can reasonably and easily infer that the private eurodollar system had run into liquidity difficulty as far back as March, heightened substantially in May and June. Given the action in gold and then repo collateral, we can start to piece that together with the sudden steepening in swap spreads as far back as February. If dealers were eagerly underwriting the floating side of IR swaps in the announced "semi-permanence" of QE3, as Bernanke was emphatic about "open ended", any chance of reversal would cause not just a repositioning of contract values but also collateral. With interest rates and spreads suppressed near-zero, it doesn't take much nominal change to trigger collateral calls. In short, whatever ultimate was responsible for the shift in early 2013 turned out to be a highly expensive proposition, all around, for money dealers.

When you count that into the overall liquidity equation, particularly that dark leverage and wholesale funding is quite incestuous (and therefore shockingly fragile) to begin with, the great disruption in the middle of 2013 starts to make sense in its glaring asymmetry. That isn't even conjecture, as just a few months after banks themselves declared an end to the short-lived fun; FICC desks were slashed in Q3 2013, with layoffs all across the mortgage sectors misleading the fact that banks were really ditching money dealing and dark leverage for good this time.

The events of November 20, 2013, enter prominently into this process as well even though I still have no idea what actually took place that day. From the perspective of dark leverage it is clear that whatever happened simply reinforced the decision to remove as best as possible exposure to wholesale money dealing. I think the reasons for that are relatively easy to figure even if all these specific details might not be; money dealing, as any activity, needs to be (sustainably) profitable for some firm to do it. FICC in the pre-crisis era certainly was, as the flow from warehousing and dark leverage "writing" was booming though we know it as "proprietary trading"; until suddenly it was an albatross that nearly cost every dealer its solvency.

The second reconstitution of dealing surrounding QE3 was, I think, the last ditch response to try to make money dealing profitable again - to ride the intended QE3 effects on fixed income prices and derivative collateral flow as it was intended to be somewhat longer term. After all, with nominal rates pressed low everywhere, and zero in far too many places, there wasn't enough to pocket decent spreads for the actual risks since dealer activities and prop trading from before were essentially dead. It took only a few months for dealers to get burned yet again, so you can understand why they might have sought permanent exit.

That is the theme in banking in 2015, as the global behemoths that once constituted the bulk of global money dealing and balance sheet capacity for dark leverage no longer want it. Even those CEO's that had resisted the buzz word of "restructuring" to this year were let go; bigger is no longer the primary banking objective which has very important global implications in the wholesale context - if former dealers aren't going to do it even in a shriveled state as that around QE3, who will?

The "dollar" turmoil around the world is, of course, exponentially greater in 2015 than 2013 which goes to show that banks have, by and large, stuck to the plan. Into such global retreat in "dollars" and funding, it is little wonder that any central bank has been able to accomplish much of anything - let alone the gathering downdraft such illiquidity portends not just for "inflation" but economic function as it relates to financialized economic margins. The ECB (the euro is, after all, a wholesale currency itself with the very same banks that supply eurodollars also supplying euro balance sheet capacity) just today announced essentially that its QE, near its half-birthday, hasn't worked at all. The Fed refuses to raise interest rates and the PBOC just experienced perhaps its most desperate period (in a "dollar" run, of all things). The list goes on.

In more general terms, what we see of this wholesale history is just the illusion of control. Starting from a bland and generic perspective, monetary theory was always just an illusion but one in which its greatest potency was upon its own practitioners. If the Fed offered anything these past few decades, it was pure delusion that it was in control.

The lever of control was supposed to be interest rates, as in the Fed shifted from targeting reserves to targeting money supply to targeting the federal funds rate. The reason for those changes were, first, utter failure in the Great Inflation. The FOMC belatedly realized that the character of the financial system, both domestic and globally, was changing dramatically and that the "old ways" were beyond imperfect. It was as early as December 1974 that the FOMC was cautioned that new versions of money supply figures, an updated M3, was needed as the traditional estimates weren't any more correlating with expectations - meaning banking, inessence, was doing other things not captured by policy actions.

The shift to interest rate targeting in the 1980's was, in a way, giving up on defining the money supply; instead, targeting the federal funds rate and assuming that would catch all the various and new forms of funding and "money" that innovation had brought forth. That effort was completed in late 1990 when Regulation M was modified so that eurodollar balances would receive no capital or reserve charge. It didn't matter, so monetaristic thinking went, because it would all be covered by the general interest rate target.

The idea of targeting itself is not just control, but control as both stimulus and constraint. The first part seemed obvious, but that was more so because it was the natural direction of banking and money in the first place; especially where money itself was changing into something else entirely. It has been the second part where the self-delusion of the effort has been the most disastrous.

Even Alan Greenspan as much acknowledged that in his infamous 1996 "irrational exuberance" speech. The entire point of that phrase was not just asset bubbles but how "money" itself was no longer money as it had been previously defined. It is ineffably sad how those two words became almost immortal when instead it was their reasoning that foreshadowed everything thereafter. In other words, he was trying to argue why interest rate targeting was the best manner to control and constrain, while simultaneously acknowledging it wasn't so straightforward because even the Fed could no longer define or describe actual monetary condition.

"At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. We could convey the thrust of our policy with money supply targets, though we felt free to deviate from those targets for good reason. This presumably helped the Congress, after the fact, to monitor our contribution to the performance of the economy. I should add that during this period we maintained a fully detailed analysis of the economy, in part, to make sure that money supply was still emitting reliable signals about the state of the economy.

"Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Thus, to keep the Congress informed on what we are doing, we have been required to explain the full complexity of the substance of our deliberations, and how we see economic relationships and evolving trends."

Greenspan followed that thought with optimism that money trends "may be coming back on track" but we know that to be just wishful thinking on his part. The Fed itself gave up totally less than a decade later when it stopped publishing M3 altogether. That was with good reason, as M3 was by that time greatly misleading as it did not contain much of the full volume of eurodollar saturation and wholesale "supply", but was truly never set up (nor are even traditional balance sheets) to capture the motions and spins of dark leverage and the like. The idea of control and constraint through quarter-point changes in the federal funds rate is reduced to tragic hilarity in that context. Serial asset bubbles are thus not the spawn of "ultra-low" interest rates but the extensive and extended superstition of monetary control and constraint via generic simplicities.

I think that perfectly sums up the aggregate demand voodoo as it got us to this pitiful, ideological point including why the "dollar" is dying in 2015 no matter what central banks throw at it - just as it rose no matter what central banks tried to impose upon it. That is, after all, the chief problem with illusions; they aren't a dependable basis for much of anything. And they die truly hard, as we only have to go back to April this year when the 30-year swap spread "unexpectedly" turned as negative as it had been since 2012. Right on cue, Reuters was this time there to assure us that it was heavy corporate issuance and still-lurching normalization rather than stark, dangerous and global illiquidity in dark leverage yet again.


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

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