The Global Economy Is Caught In the Trap of Central Bank Rogues

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Just a little over three months ago, the US Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the US Securities and Exchange Commission, and the US Commodities Futures Trading Commission all issued a joint staff report on the events surrounding financial trading on October 15, 2014. Filling out a rather chunky 72 pages, the report actually comes to no conclusion other than to spill an enormous quantity of virtual ink upon only one 12-minute episode. The world was left nearly speechless at that day's ferocity, but the government and its "impressive" roster offers only that some computers were involved.

Such a view is problematic in too many ways to count, not the least of which was the primary expression of irregularity being essentially a "buying panic." We may have become far-too-accustomed to the fury of unrestrained selling these past eight years, but one year ago yesterday was perhaps a first in history where fright and horror was unleashed in an overwhelming flood of US treasury purchases. You can thus understand any government interest in at least dispelling how that might have been anything like or close to "fright and horror." That market is supposed to be the most liquid and dependable in the world, and yet it broke, blighting the very thrust of the predominating narrative of "normalcy." Janet Yellen has been saying since her first day in office that the Fed has had at least one true success, that being reinstating good working order in global financial markets; "resiliency" as she is wont to refer to it.

Liquidity holds no such sentimentality. It either is or is not; when it is not, there is big trouble. From that view, the traditional convention about the subject is already in desperate trouble, as Treasury's report makes plain in the fourth paragraph of Section 1 (on liquidity):

"The U.S. Treasury market enjoys liquidity defined more broadly, with continuous trading and substantial market depth. However, on October 15, specifically in the 12 minute event window, the U.S. Treasury market-while in one sense remaining liquid as participants were able to continuously transact-experienced uncharacteristically shallow market depth. Moreover, the continuous trading in these 12 minutes seemed unrelated to any new information, leading to questions about the efficiency of price formation in the Treasury market during that time."

Thus computers, or something. While downplaying what liquidity is, the report hijacks the whole intention. Liquidity is not what there is today, or what you expect tomorrow, but what any system can deliver at its worst moment, much deeper than being able to "continuously transact" but rather being able to transact at non-disruptive rates and prices. The events of last October 15 qualify entirely as "illiquid."

The 10-year US Treasury yield closed October 14 at 2.21% but traded down to 1.87% not long after the open (on heavy, heavy buying). That 34 bps move in yield would have qualified as one of the largest single-day moves in trading history; had it held. The last time there had been a 20 bps downward move in the 10s was August 9, 2011, right smack in the middle of the heated euro/"dollar" crisis that saw global markets crash severely, with wholesale liquidity right there again at the center. The last time there had been something more than that was March 18, 2009, within the ashes of panic, flushed with central banks and their always-too-late massive alterations. In short, these kinds of days don't come all by themselves.

That is, however, the view you gain from the Treasury report, as if irregularity in US treasury trading was the full and total extent of the hoopla. That just wasn't the case, as global stocks sold off hard into that day and, more importantly, credit markets and the junk bubble were especially thwarted (in that usual frenzied selling format). The market value component of the S&P/LSTA Leveraged Loan 100 index experienced its largest two-day selloff since the middle of 2012, before QE3 and Draghi's promise. That leveraged loan and junk bond selloff ended October 16, 2014, the day after the Treasury report closed the book on 12 minutes of computers communicating faster than people on telephones and IM's.

In fact, there were continued rumors in the days before and after October 15 that corporate credit pricing was unusually spotty and illiquid. The Wall Street Journal reported exactly that on October 16. Computers might have been part of the mix, but far more so at the end than the beginning. The beginning (the "why") is what is truly important:

"Corporate-bond investors have struggled this week to find trading partners for some large orders, causing unusual price drops and raising concerns that trading could freeze in future market turmoil.

"‘Buyers just disappeared' early Thursday for many low-grade bonds and even some higher-grade ones, said Jason Graybill, senior managing director at Carret Asset Management LLC, which oversees $2 billion."

Despite what convention declared at the time, and still clings to now, there was every reason to suspect such a broad disruption then. The repo market perhaps was the first to signal broad liquidity despair. In earlier June 2014, suddenly and out of nowhere, repo fails surged to the highest since mid-September 2011 (the euro crisis comparison again); jumping from a combined total (both to receive and to deliver) of $130 billion during the uninterestingly normal week of June 4 to $388 billion the next and $402 billion after that. Tellingly, the fails problem kept at it intermittently all through late summer cresting with yet another surge the week of October 15. And all the while that disruption took hold and deepened, the Federal Reserve's reverse repo program sat in its unshaken and unnoticed slumber.

The reverse repo program was, among other "exit ideas", intended to help alleviate any surge in collateral shortages such as that which began the week of June 11. And so we begin to place in order the dots that trace from lethargy and indifference in reverse repos to the Fed's participation, and Treasury's acquiescence, in a report that declares nothing truly interesting about October 15, 2014. It is the perverse logic that infects the deep heart of monetary orthodoxy, the same specific weakness that failed so spectacularly starting August 9, 2007: the Fed develops a specific crisis formula and program and if it never gains use then the Fed concludes there was/is no crisis. This is beyond backwards.

Indeed, that is what has been written into the FOMC minutes ever since the reverse repo program began testing years ago. In the late summer of last year, the FOMC gives the reverse repo program full endorsement publicly while very quietly moving on to other "exit" strategies. It seems, likely to them, a harmless vice, to declare open success on something that they would no longer rely upon for any success going forward. In understanding the latter one might be forgiven for thinking the US central bank has no idea what it is doing and is instead relying solely upon reputation that it comprehensively knows what it is doing where all evidence points against it.

As idiotic as that sounds, it is, in fact, the declared preference of Janet Yellen. Just a few months before the events starting off in the repo market, new Fed Chairman Yellen professed exactly that:

"Specifically, it is important for the central bank to make clear how it will adjust its policy stance in response to unforeseen economic developments in a manner that reduces or blunts potentially harmful consequences. If the public understands and expects policymakers to behave in this systematically stabilizing manner, it will tend to respond less to such developments."

It is an alarmingly chilling passage in an otherwise bland nothingness of a speech. She is suggesting that markets no longer act as markets, instead give over all thinking and reasoning to unconditional love and obedience to the central bank. By doing so, she "reasons", market agents no longer have to worry about anything except how much to get paid; Big Brother Money will take care of all potential downside in any possible iteration or outbreak. It would be naïve to assume the Fed's changed stance on the reverse repo program as well as the Treasury report on only 12 minutes of October 15 are not well within these designs.

Being an incredibly foolhardy intention on the part of any serious institution it is but one that fits well within the modern orthodox view of how everything works - on and of emotion. Rational expectations theory has become nothing more than that, attempts, childish mostly, to manipulate nothing more than emotions; to maternally soothe any harsh worries as if a QE or two can correct any insufficiency, which is itself assumed nothing more than overdone simplicity emanating from the irrationality of the general rubes who don't know any better.

Examining the true extent of what central banks can actually do, one can only conclude as much. QE doesn't actually do anything, and certainly holds not a fraction of the power and authority by which it is still claimed (which is, tellingly, itself a fraction of what was once described of it). Monetarists offer the world not money, but tales and moral suasion.

The world itself, however, runs on money, at least in the financialized version of the economy. It is indeed interesting to examine in close detail the world's great banks and find them purposefully eschewing the shadow banking activities that once nearly brought down the whole thing; and then realizing the irony that banks are doing so not to offer a plausible way out of the economic mess but rather because central banks were so committed to what I described above and perhaps assuring that we do it all over again. For all the bluster about shadow activities in 2008 and 2009, central banks have embraced them in this recovery as the only means to project the only recovery central banks wish to perform - financialized. The biggest banks have only gotten bigger by no accident of coincidental circumstance.

Janet Yellen's soothing fairy tale about an all-powerful FOMC was meant surely in part for you and me, to forget any and all our economic worries and embrace great indebted spending over and over again as we once did, but even more so for the trading desks at the eurodollar behemoths to supply freely, as they once did, the credit that so saturated GDP the past few decades. In one more twist of irony, this one proving fatal so far, it was the events of October 15 that seem to have accelerated her fairy tale's implosion.

Coincident to the arising repo strain starting in June last year was, of course, this "rising dollar." At first, it was embraced, as it could not possibly have meant anything other than the Fed's final victory over the "pessimism bubble" as it was once called. The thing was even offensively given the term "strong dollar" no matter how much economists have forgotten about what stable money actually is and consists of; no matter, with everything seeming to be going right and all the mysterious "headwinds" of the past fading into trivial obscurity, the fairy tale ending was so close at hand. Yet, October 15.

Underneath it all it was much, much worse than even the repo malformation implied. Eurodollar banks had been cutting back since August 2007, but in discrete formations and episodes. The last had been from the middle of 2013, the taper drama, forward. But some banks held fast, buying once more into the longing fancy of that recovery and Janet and Ben's ultimate victory. As I have noted on several occasions, global giants like Deutsche Bank and Credit Suisse charged into what they saw as huge opportunity against the receding "dollar" tide of their peers. And what else would it be except the grand splendor of opportunity? A full recovery could not be more so, meaning that Deutsche and CS should have been the leading edge of that return trip, the fanciful flight of dark leverage once again flowing into the financialized economic coffers of full and bright recovery and boom. Behind it all, the mindless embrace of Janet Yellen's nightmarish totalitarianism.

That is exactly how it is turning out, as those firms have not so proven the imaginary as instead absorbed the new scars of the folly for all to recognize yet once again. It was October 15 that unleashed the fury of the thus amplified equation, namely that the "dollar" was not "strong" or even rising so much as revealing the end of all that. Not two months later, the ruble crashed in early December 2014, followed closely by junk credit yet again, this time more serious on December 16. Then there were the events of January 15, 2015, where the Swiss National Bank shocked the world by bowing not to the euro but that extinguishing "dollar" reality. And so it has gone, one after another, in the rising crescendo of what is almost clearly (by virtue of August) now a gathering storm.

Central bankers gathered in Peru recently were stumped, mystified how $800 billion in "hot money" could simply disappear this year. Likewise, "experts" and convention are bewildered over the nonsense of swap spreads dramatically compressing and turning negative once again, and down to shorter maturities never thought able to threaten that zero boundary. None of them ever stop to appreciate that connection, where the Bermuda Triangle of "hot money" might intersect the nonsense of negative swap spreads, and all tying back toward an event that authorities have tried their absolute hardest to deny significance to.

It is exactly the nonsensical idea of swap spreads that reveals the malady; it takes great imbalance of liquidity and capacity to produce, like trading on the morning of October 15, radically altered perceptions to the point of ubiquitous confusion. A negative swap spread makes no literal sense apart from an ill-suited surface convention that the "market" is viewing the US government as more of a credit risk than a private financial counterparty. The idea of UST's as "risk-free" has always been overdone, but not anywhere close to that level. Instead, it, again, takes a huge imbalance to manufacture such gibberish, so much that what is important is not trying to maintain the literal sense of what "should" be interpretation but instead to appreciate the dire condition that might force such recognition. If swap spreads aren't making much sense, then we can only conclude that global eurodollar bank balance sheet capacity is severely constrained in the same money dealing activities that deliver broad order.

The real tragedy here, if there is one to be found, is that this is all obvious to anyone with a minimal level of curiosity - you don't need the fancy dressings of a central banker, decked out with impenetrably elegant orthodox regressions of correlations that have no bearing on real world function (instead being useful only in trivializing long ago machinations), just click on over to EDGAR and tear open any dealer bank's balance sheet, or even just observe the continual tempest of negative FICC "revenue." If there is still money left in this financialized world (and there really isn't much of it other than conditioned acts here and there), it is there.

From that you are forced to conclude the global banks that made the financialized economy are in full retreat everywhere. Not even the stalwarts, those that listened too closely to Yellen's siren song, are aching much for the eurodollar anymore; they are getting out faster than those that preceded them. The numbers are staggering in absolute terms, but far more depressive in relative terms for what the financialized global recovery should rightly need to fulfill central bank fakery.

JP Morgan's gross notional interest rate swap book has declined (through Q2; I can only imagine what that might be when the Q3 figures, incorporating the events of August and September, are published) by $14 trillion (-26%) since the middle of last year, this "rising" or "strong dollar." Bank of America (Merrill Lynch) -$10.7 trillion (-24%); Credit Suisse -CHF14.7 trillion (-27%); UBS -CHF5.5 trillion (-30%); Goldman Sachs -$4.8 billion (-10%; though I suspect that will be a much larger negative after the FICC quarter they just handed in) and on and on. All of those figures are just gross notionals reported for interest rate swaps, but that is the beauty of such simplicity. You don't have to understand all the angles, all the intricacies and complexities of why dealers might take both long and short, fixed and floating and everything in between. You don't need to note convexity or its nefarious opposite, negative convexity, or to even know what correlation skews might do to a whole eurodollar pack, white through gold. To tally gross notional derivative books in this way is to fly above all that and realize, despite the imperfection of such a proxy, that these numbers indicate an aggregate intention of participating in the dark leverage that sustains the eurodollar in all its forms; including global market liquidity.

And there again we have our answer to the nonsense of swap spreads this year, especially of August and beyond, as the banks themselves are telling us in no uncertain terms that they are not committing the capacity to maintain even unquestioned convention in those prices. If capacity cannot answer the mechanics of orderly function in interest rate swaps, there is no intuitive leap necessary to go looking for that lost $800 billion in "hot money"; as it is not hot money at all but the dramatically receding tide of the eurodollar itself. It is all connected by design; ad hoc and haphazard, but design nonetheless.

That includes, unfortunately, the global economy as it is caught in the trap of these central bank rogues that have doomed it to financialism or nothing. The world is suddenly and stunningly, if only from believing in last year's fairy tales, looking more so at nothing. Rather than dismiss October 15, 2014, out of hand in favor of the Yellen brand of utopia, economists and policymakers would do much better to start realizing it was the last straw.

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

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