The World's Great Money Markets Are In Desperate Revolt

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To understand that linearity in history is an exaggeration is to find out a lot about the nature of human endeavors, and how they so often fall far short. Progress even with a small "p" is often incremental, a fact that seems destined to be mistaken for a straight line. Perhaps this is more so in theoretical understanding, touched with currents of philosophy and, yes, sophistry, than with the mechanical, analog detachment of daily life. Computers and technology provide us with a seemingly direct line forward, but understanding what the means in actual life is just a little more complicated.

The circular nature of events is often astounding, as if the great hand of time is actually wound and reset almost at regular intervals. Whether you believe in the Fourth Turning or not, you really can't deny the symmetry and consistency of existential crises in America, coming almost exactly every four generations. The players all change, the words and terminology sometimes unrecognizable, but the game itself is constant; always underneath and with just enough visibility to pose almost the Sisyphean root. We think that we have found progress, or even Progress, only to come across not a new plane of operation and solidly beneficial existence but rather often belated recognition that we have just updated the past's performance; the "antibiotic apocalypse" proving the method maybe a little too uncomfortably of late.

Milton Friedman gave a speech in 1960 where he described this phenomenon as a starting point by which to implore monetary officials to promise a passive monetary regime of steady money supply. At one time, money supply was the prominent focus of every economist researcher, only to be replaced by the next generation who gathered no concern at all about money.

"The profession of economics as a whole then shifted very radically from one course to another. From a general belief that the stock of money and the changes in it are tremendously important in controlling economic affairs, the profession shifted toward the view that money has little importance and does not matter except in rather trivial ways. It shifted toward the belief that the important things to look at are the flows of investment expenditures, on the one hand, and consumer expenditures, on the other. It was said that if these are taken into account, it really does not make much difference what happens to the stock of money."

Friedman was making the argument that money does matter, which is rather odd given that his direct disciples and descendants no longer feel that way. They have gone back to the previous school whereby "aggregate demand" rules and that the means to get there is of no great importance, a triviality for trivial pursuits.

To prove this point one need look no further than Ben Bernanke himself. In practice, as well as theory, the genericism of his entire career permeates. The Federal Reserve and its policymaking body, the FOMC, just "stimulate; by "easing" or "loosening." What, how, where, through which method or means; who follows, can it be observed? None of these questions matter; stimulus stimulates because it is stimulus.

It's an odd supposition by which to build the whole great foundation of modern central banking and the financialized economy it has resulted. Before 2008, if you asked any FOMC member how they "controlled" the economy they would respond by telling you how the FOMC directs the Open Market Desk to manage the federal funds rate so that the effective (market) interest does not deviate from its target. And if you further examined exactly how the Open Market Desk carried out that "control" you would have enjoyed the preset pabulum about open market operations, where the desk buys and sells treasuries to alter the quantity of reserves as needed.

Of course, if you actually go back in the historical record to find the footprint of such mechanical control, it doesn't exist. The quantity of bank reserves was almost perfectly constant for decades; until QE.

Just prior to QE1, however, the Open Market Desk was provided an abject lesson in this kind of circularity. The effective federal funds rate in the most acute episodes of the panic (there were actually two phases of a singular, burning trend; one that began in August 2007, and one that renewed in the summer of 2008) did tend to deviate, but not in the direction a liquidity panic presupposes. Unlike LIBOR, the effective federal funds rate found itself often below the target and at times inconceivably so. That was how in September 2008, just after Lehman Brothers set off a still-unbelievable chain of implosive liability relativity, the Federal Reserve was, by traditional and typical count of itself, "tightening" monetary policy.

In the real world, of course, the Fed was doing no such thing; they were simply responding to their mandate which had been, by that point, conclusively proven as far, far outdated. It was such a peculiar turn for the economists-as-money-policymakers but one that should have been foreseen by all of them. I have referred to Alan Greenspan's "irrational exuberance" speech perhaps one too many times, so here I will instead present a passage from Ben Bernanke himself speaking in 2006 (just after referring, ironically, to the 1960 Milton Friedman speech I quoted above):

"In 1960, William J. Abbott of the Federal Reserve Bank of St. Louis led a project that resulted in a revamping of the Fed's money supply statistics, which were subsequently published semimonthly. Even in those early years, however, financial innovation posed problems for monetary measurement, as banks introduced new types of accounts that blurred the distinction between transaction deposits and other types of deposits. To accommodate these innovations, alternative definitions of money were created; by 1971, the Federal Reserve published data for five definitions of money, denoted M1 through M5."

There was much more than that, as monetary distinction itself has been something of an uncomfortable topic these days, just as it was in that momentous age where Bretton Woods and gold were being lustily removed. It's not enough to simply nod at the coincidence of the Great Inflation and these monetary evolutions.

They were noticed in practice almost everywhere, and that included Switzerland. The old joke about the Swiss National Bank is that it has been the most honest, most stable central bank in the past century; the franc has only lost 86% of its value since being founded in 1906 (by act; 1907 in practice). The Swiss had always been quite sensitive about the franc and its value, a factor predating the central bank. Like the US, for the 19th century currency was a matter of local banking; the centralized clearing bureau, let alone a unified currency issuer, was a 20th century set up. Despite those still meaningful similarities, the Swiss National Bank, unlike the Federal Reserve, was highly dedicated to franc stability.

Thus, in the early 1970's, SNB was beset by tremendous insecurity owing to that tendency for safe haven-driven appreciation. On May 9, 1971 and again on December 18, 1971 (bookending the August 15, 1971, dollar default) the SNB re-valued the franc to staunch the flow, to little avail. The internal money supply exploded in February 1972 by a 60% annual rate, and again by 30% the next month. The franc, it is important to note, was still fixed at that time, so by the end of 1973 "inflation" was running at more than 11%; making Switzerland nearly indistinguishable from the basket cases like the UK and Italy (or the US).

The Swiss could only withstand so much, so that on January 23, 1973, the SNB abandoned its fixed franc value. The severity of that cannot be overstated in terms of the Swiss banking "honor" that prevailed. That left monetary policy at least in undetermined territory, a veritable No Man's Land that far too many central banks found themselves navigating at the very same time. By 1975, the SNB, like others, decided upon targeting the internal money supply, particularly M1.

It was never truly feasible, however, particularly given the shadow cast in international finance by the Swiss banks. The SNB could not be left to internal money mechanics alone, a fact that they demonstrated in 1978. In October that year, with the floating franc once more appreciating as the world, monetarily and otherwise, spiraled out of alignment, SNB suspended its monetary target in favor of enforcing an exchange rate floor against the German mark. Crisis and the potential for great economic damage provided the means for altering monetary "rules" with which to act sometimes in contrary fashion.

If that all sounds familiar, it is an almost exact forebear of the Swiss experience from September 2011 through January 2015. The exact form and means of SNB action are, again, different but the nature is exact duplication. To counteract serious questions about the euro as it came flooding into Switzerland's borders, and with appreciation of the franc, SNB "pegged" the franc to the euro by threatening to defend 1.20. They were tested on several occasions, particularly later in 2011, but the line in the sand held.

From that view, it has been difficult for the mainstream to assess the events of January 15. Out of the blue, the SNB just deserted the euro peg and left the franc to its own devices clearly contrary to all its stated purposes from just before. Trying to make sense of it, mainstream convention has been distilled down to the same troubles - the SNB balance sheet only as money supply this time.

"In theory, the SNB could have continued to build up its balance sheet without limit, comfortable in the knowledge that it could print unlimited Swiss francs to cover any foreign currency losses in the future if the franc rose. However, in so doing, the traditionally cautious central bank might well have landed itself with even bigger financial stability concerns than those it has been grappling with hitherto - ultimately, about the consequences of open-ended money creation. The monetary base has quintupled to SFr400bn since the middle of 2011, property prices and rents are increasing rapidly, and bank lending has risen by 25 per cent as a share of GDP to 170 per cent."

In other words, the SNB's troubles are being traced to the ECB and the euro because that more closely recounts what commentary has assembled of past transgressions. This sets up a rather easy and testable thesis; if the SNB's balance sheet size was the primary consideration in removing the euro "fix" then its removal should have greatly reduced the SNB's balance sheet expansion if not stopped it altogether.

It hasn't; instead, the balance sheet expansion has "somehow" gotten worse. Since the end of January, the increase has been by more than 10%. All of that has come in the form of additional held forex "securities", the kinds of wholesale finance that are often mistaken as "reserves." Of those, by far the most are "dollar" "reserves." In short, Switzerland's big problem in 2015, really going back to June 2014, is the "dollar" not the euro.

Though, if we are to be specific and precise, Switzerland's problem is once more the same as everyone else's, which is weirdly and eerily the same as its own problems in 1978 - the evolution of money. In that respect, the troubles of today were wholly foreseeable except that monetarism and orthodox economics spent the better part of four decades doing everything they could to deny it. Central bankers had instead placed their own task as searching for some settled state, no matter how brief, so as to substitute as governable human nature by which they could raise their flag of soft central planning. An evolving money supply would (let alone a fast evolving one and by now generations and generations further along), by its very nature, call into immediate question any such static assumptions as would be required by central planning; a fact amply displayed by the chaos which prevailed throughout the 1970's.

It would have been impossible even by the late 1980's to have foreseen just how far technology would drive "money" to facile working status as we see today, but the contours of the possibilities were quite visible even as early as the 1960's. In other words, no one might have predicted just how money would change, or how far that has gone, but they should have been assured that it was already doing so. As I have noted before, the Fed was quite seriously considering the implications of the eurodollar in the late 1970's but then it's as if all work suddenly went completely silent on the matter. As Milton Friedman suggested of his view of the theoretical ages that preceded him, the study of money cycled far out of view in favor of "aggregate demand" and generic economic accounts. Nobody quite knew what was going on in banking, but they didn't truly care, either.

By the early 1990's, banks and dealers were scamming the government at treasury and especially MBS auctions and tender leaving a mainstream puzzle of contempt for the impenetrable "illogical" of it; contemporarily these were called "inept little scams" as even the experts ventured no further than the surface. Of course, what had already taken place by even that early point was no less than a revolution, presaging the coming age of collateral and securitization; upending not just notions of currency and money, but even value and what might pass as riskless and financial dependence.

It is one of the most hardened assumptions of monetarism, as in the only real aspect of the theory that attempts to penetrate beyond the bland appreciation for money, that interest rates are segmented and governable. That starts with the UST rate as a benchmark demarcation of risk and riskless. In June 2003, Alan Greenspan left no ambiguity about it, essentially declaring it as ironclad law of monetarism and monetary control especially where new boundaries, such as the zero lower bound, had already come into view. He declared:

"It's really quite important to make a judgment as to whether, in fact, yield spreads off riskless instruments - which is what we have essentially been talking about - are independent of the level of the riskless rates themselves. The answer, I'm certain, is that they are not independent."

Only five and a quarter years later, it all came crashing down. I'm taking the meaning of swaps spreads in this instance, which at a negative spread to commensurate treasury was in direct and holding violation of this basic and core tenet of monetarism. QE was disproved before it was ever started.

Thus, we are given a bookend by the start of QE and ZIRP and now contemplating their dismissal. Just as swaps spreads were negative, in at least the 30-year maturity, then, they are now so across almost the whole curve. While it has yet to break open into mainstream discussion, I can assure you that it has already created a major force of unease throughout at least the deeper ports within the financial world. From Bloomberg:

"Everybody in the fixed-income market should care about this," she said...

"Traditional pricing and relative-value rules are breaking down," said David Goodman, head of global capital markets strategy at Westpac Banking Corp...

"This is not really just a somewhat esoteric story about interest-rate derivatives," strategists led by Joshua Younger wrote in a Nov. 6 report. "Moves in spreads should be viewed as symptomatic of deeper problems."

But where financial participants are upended, economists remain resolutely unimpressed. For one, the chief and holy priest of orthodox tendencies, Janet Yellen has put the Federal Reserve, supposedly, back on course to end ZIRP on December 17. One of the primary rationales for delaying off at least the September meeting was "global financial upset." To her view that has been cured (only stocks are important?) but only in snubbing "her" own banking system.

And so it leaves an extremely chilling dichotomy that says a great deal about where we are, and why that is. Just a year ago, the FOMC was quite unsure, and curiously open about it, exactly how it might truly go about raising rates. It seems an odd thing to be concerned with given the surety by which all monetarism projects, but that was, once more, a slight acknowledgement to the insufficiency of the generic monetary position, pre-crisis, that I described above. The federal funds rate, by any count that is meaningful, just doesn't matter - in relative and proportional terms, there is nobody there.

Because of that, the Fed spent much of 2014 and early 2015 testing peripheral "tools" which were supposed to augment its ability to actually carry out a rate hike. That was especially hopeful first in the case of the reverse repo program (RRP), until testing found no real impact (especially upon the events at the end of Q3 last year leading right into October 15, 2014). The RRP was then quietly declared a success even though the FOMC moved on to something called the Term Deposit Facility (TDF). The TDF was quietly declared a success and now the FOMC speaks about term repos lasting past December 31.

The central element in all of this is clearly the idea and ultimately the illusion of control. At each turning point in history, these grand inflections clustered around great and global crises, we cycle back to that very flaw in centralized behavior. Experts and scholars think they figure out what eluded their antecedents, the methods and understanding that allow them to create the steady state and rigidness that is demanded by controlling tendencies and tolerance. Instead, they only find, after some time, that "money" evolves beyond all that because nothing human ever really stands still.

That point has been met with an unusual emphasis since August 9, 2007, yet economists still don't seem to care. In fact, they are, at this moment, busy proclaiming that nobody should pay attention to any of this to instead revel in an interest rate and control lever that no financial agent finds significant - including, rather constructively, the Fed itself. For their part, actual money markets, which in this evolved existence includes factors that seem nothing at all related to money or monetary characteristics, are no longer just highly agitated as they have been since last June (and really going back longer than that; there is and has been a quite detectible crescendo that appears in rising or intensifying cycles and outbreaks). In fact, you could make the case that the Swiss National Bank's misunderstood antics in January mark the first serious amplification of all that; central banks have been tumbling to it ever since.

And so the world's great money markets, the "dollar" as it were, are in a state of open and desperate revolt at the very moment Janet Yellen will use a relic of the monetary past to proclaim the solidification of the future. This is no Broadway or Hollywood production; it is a Monty Python skit and a rerun at that.


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

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