Janet Yellen Confuses 'Doing Something' With Growth

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To Aristotle, the nature of an object determined its behavior and more than that its very essence. Explaining that object or process would not be left to observation or experiment, but in deduction of the object itself. Since all the relevant factors originate within the object, everything depends upon the object's thus unobservable nature. The abstract process of deducing that nature circumvented all other methods, formal or otherwise, of "scientific" endeavors about it; we should think first about what an object is and thus what it "should" do and how it "should" behave by that nature, and then fit actual observation within that thought paradigm no matter how difficult.

The tendency to work backwards in that fashion led Karl Popper in 1950 to decry:

"The development of thought since Aristotle could, I think, be summed up by saying that every discipline as long as it used the Aristotelian method of definition has remained arrested in a state of empty verbiage and barren scholasticism and that the degree to which the various sciences have been able to make any progress depended on the degree to which they have been able to get rid of this essentialist method ."

In that view we find the current state of the US economy and "modern" economics, staring into the face of a manufacturing recession that no economist finds the least bit troubling. Quite the contrary, a full-blown recession in manufacturing has been put to rest as "only" 12% of the economy. That figure, which suddenly appeared only recently, is meant as the equivalent of "nothing to see here." The fact of its introduction is even more specious given that even a manufacturing recession was just a few months ago believed "impossible."

There is no mistaking the growing contraction in productive activities, though it is hard to make any case where manufacturing is unattached to anything else. Goods aren't just produced, materials have to be found, drawn or mined, machined and transported. After assembly, finished goods are again conveyed through several levels of the supply chain and then sold and resold. In that fashion, seeing factory orders decline (Y/Y) for the twelfth consecutive month in October, and at a greater and greater rate, qualifies as just that kind of instrumental confirmation. Meanwhile, inventory remains at record levels.

Even if it were left as if manufacturing were an island and that 88% of the economy were so able toward isolation, one's first instinct upon admitting that one-eighth of the entire economy were in justified recession should not be to so easily reject. For the first, it should engender some minimal amount of curiosity as to why that might be before proceeding thusly and forthrightly to "nothing to see here." After all, as even orthodox economists are usually so quick to remind, there are feedbacks at stake.

It's not just a manufacturing recession, however, as that was actually preceded itself by a "profit recession" and truly a "revenue recession." By just words alone, Aristotle be proud, that's an awful lot of recession being applied to fundamental circumstances. As Bloomberg reported just over a week ago, total profits for S&P 500 companies, cumulative, for the first three quarters of this year were about $804 billion compared to $828 billion in the first nine months of 2014. On the revenue side, S&P 500 businesses are short by an enormous $287 billion compared to last year.

"'The question for us is not are we in a U.S. profit recession, but how bad is it likely to get and what are the implications for the wider U.S. economy, and with that massive consensus long on the U.S. dollar,' they [Societe Generale quantitative analysis research team] write."

All of that has produced a collective shrug from the mainstream of economists, FOMC policymakers at the forefront of the disinterest. It's the dollar or somebody else's problem overseas, and even if it did matter it's only "transitory." Mainstream economics has become the very essence of Aristotelian "science." Yellen is absolutely sure that there is a recovery coming, so the "essence" of the economy thus defined must drive and color instead all observation - particularly those that no longer suggest anything like it. Economists have for some time been working just that backwards, starting from "next year's" recovery and filling the gaps with increasingly misapplied sophistry (which is what that "12%" stands for).

A full part of that extends to the dollar itself, which is nothing like the "dollar" of actual and observable existence. It was itself an article of distinction also not long ago where the complaints over the dollar today were instead useful "market" projection of a "strong dollar" which seemed to conform to the only-recovery crux. It bears repeating that a truly strong dollar had nothing to do with the exchange rate nor any price, but rather the widespread view that an economic system remained on such staid and solid ground as to be in no danger of undergoing a run or devaluation. It was, in perfect simplicity, highly and fruitfully stable.

In these later months of 2015, the "strong dollar" makes only sporadic appearances in commentary, mostly because now the intrusion of the "recessions", while "dollar" runs and general global financial instability the far more common context. It may be treated as pure coincidence in the backwards nature of contemporary economic thought today, but stability still counts for a lot. Thus, it isn't actually surprising that manufacturing recession would show up where the "dollar" had become so visibly and corrosively unhinged of late.

It is how the "dollar" has become so that is of importance now. Here, too, economists work backward from the casuistry assumptions about money and money supply - the Fed, in particular, has supposedly flushed the banking system with trillions in "reserves", and therefore there can be no monetary instability. Any observed unsteadiness, of course, is thus likewise dismissed, derided or just ignored entirely. That point includes rather conspicuously the great and easily identified facts of the banks themselves. One after another, especially this year but really dating back to 2013, they have announced their intentions to withdraw from the basic activities that sustain and drive the global financial system. Colloquially defined as "bond trading", it is in their accounting parlance FICC and includes not just fixed income but money dealing and especially dark leverage through derivatives.

The latest to do so is Morgan Stanley. The firm announced this week that it would cut as much as (but not limited to) a quarter of its "bond trading" staff and resources worldwide. Here, too, mainstream convention works backward and assigns more comforting and conforming interpretations that might explain this contrarian behavior while carefully preserving the recovery starting point; in other words, regulations.

But Morgan Stanley's CEO was uncharacteristically blunt in assigning the true nature of the distaste. FICC revenue had, after all, plunged 42% in Q3 after several nearly as dismal quarters before it. In short, there is no "money" to be made in money dealing that has no money in it:

"The trick for us is to size our business appropriately to what we think the fee pool is...[to] make sure we have enough flex or leverage that when the markets recover, which we do think they'll recover, you'll be able to participate in the upside of that."

The problem is, as always, profit. Regulations only truly matter when there isn't any to be had - in perception more so than just the factual quarterly income statements. What is revealing in that honesty is that Morgan Stanley, more than any other Wall Street or dealer, eurodollar firm, was the perfect representation about how banks were trying to succeed in the post-crisis, QE era. The bank was quick to expand in each and every QE only to contract when each proved ineffective. In short, the bank had been betting on the recovery, with QE at its back, every time only to fall short, every time.

This has been among the only constants of the post-2009 age, as time and again the big banks, these money dealers for the "dollar" in a global credit-based reserve currency regime, stake to the recovery only to get burned. Even the memorable London Whale episode of early 2012 was exactly that. It gets lost in the shuffle of often impenetrable jargon and massively complex deep finance, but that was the entire starting point.

JP Morgan's CIO unit was developed only to make the bank money in prop trading. The institution had $350 billion dedicated to the unit in 2011and about $50 billion of that in a synthetic credit portfolio in Q4 of that year. By Q1 of 2012, the very next quarter, the synthetic credit portfolio had ballooned to $157 billion. All of it was governed by complex mathematics, including VaR and especially RWA (risk weighted assets, a very hot topic at the time due to Basel rewriting). While the basis of the London Whale problem propagated along a credit index called IG9, the last on-the-run CDX left after the panic, it was truly all over the place.

The problem really started in early 2012 when "a significant corporate issuer", the term JP Morgan's own internal report uses, defaulted. The CIO's synthetic credit portfolio was not well enough hedged to withstand that kind of "jump." According to the internal report, management directed the trading desk and unit to further correct for any weakness by searching and buying "jump-to-default" protection.

Unfortunately, such a move requires artful association and management of correlation, which is often treated instead as a purely mathematical assignment even though 2008 was a veritable flood of just such bad correlation math. Ultimately, the London Whale grew out of that element, as IG9 became the centerpiece of the mitigation strategy. The idea, as with so many of these highly complex FICC activities, "bond trading", is to simultaneously engage long and short positions but with a heavy gaze upon gammas and tranches (and gammas of tranches). This is called dynamic hedging.

As JP Morgan's report tells it, by the end of January 2012 the synthetic credit portfolio had accumulated about $20 billion in long-risk tied to IG9 10-year positions, and $12 billion in short-risk 5-year notionals also on IG9. The intent here was not just to balance long vs. short, but also to use the longs to generate premiums with which to buy the shorts. This gets to the heart of math as money. I wrote about this and the London Whale back in May 2012:

This is commonplace in modern financial firms. Complex strategies are often employed in this manner, where offsetting "bets" are used to finance other "bets". As long as everything is "netted" out somehow, it all looks proper and near riskless - this is the modern definition of "hedging". In fact, everything about JP Morgan's whale trades looks exactly like this kind of hedging strategy (whether it was really hedging or not is another topic altogether). There have been references in various news outlets of JP Morgan's CIO unit being long and short all sorts of products, across several tenors and maturities. No doubt they were using premiums for derivatives written to finance other pieces of the trade(s) structure, and probably keeping track of these multi-directional trades via some kind of sophisticated delta calculation. In doing so, that meant that there would exist hedges of hedges, and hedges of financing vehicles for hedges. Losing control of this process, through even the slightest imprecision, can easily lead to an overall position where the firm starts out short and ends up long (or vice versa) almost by accident.

That's the problem, not the solution. If the math is wrong, and it often is especially where correlations are not just difficult but increasingly so by nature of the circumstances (early 2012 surely qualified, for then, as now, there was much bleakness and liquidity issues causing pricing "irregularity" which just cannot be modeled), and convexity just so, what starts out as neutral or even short can turn long far too quickly to manage - liquidity difficulties making that management all the more unmanageable. The skew in IG9, the "whale" part, was how the trade made it obvious that the CIO unit's synthetic credit portfolio was in desperate trouble - the trade stuck out like a sore thumb as it basically advertised arbitrage for anyone willing and able (liquidity and leverage) to bet against it.

Of course, many did take that arb since it was unbelievably clear; the IG9 index was trading so far out of "fair value" alignment with the underlying reference names that the counterparty trades expanded, too. What happened, to simplify, was that correlation was way off in the models, and thus the amount of the IG9 long needed to stay neutral or even close to it was far, far more than anticipated. Therefore, the London Whale was essentially the CIO desk writing far more swaps (long means writing protection) than the market could readily absorb (dark leverage-based liquidity). The more they tried to manage their correlation problems, the more the skew on "fair value" of the index to underlying and thus the more firms could bet against what they were trying to accomplish.

The reason they were forced into that position, pinned to the trade as it were, was VaR and RWA. They needed to be neutral in order to not violate their risk covenants, even though (or because) they did already some 300 times. The math became, quite literally, a huge and numbing loss. As it was, the unit was already in talks with management about reducing its RWA footprint since the CIO directive absorbed a huge amount of the RWA "budget." The last they could afford was to be both losing in terms of profit and violating the math in several dimensions. So they doubled down again and again and again, in the vain effort to restore a hedged balance.

The intellectual value in reviewing even a simplified version of the episode, as I have done here, is more than a refresher on "math as money" especially in RWA and VaR conceptions (the bank literally held an RWA budget to assign how much desks could trade in total risk, and thus you can appreciate how dealer liquidity in derivatives/dark leverage can directly affect the internal "money" operations of "bond trading"), although that is central to the whole post-August 2007 paradigm. In this specific case, had there been more dealer appetite and balance sheets on offer the London Whale might never had stuck out so far as the CIO unit and its synthetic credit portfolio demanded a correction from its bad correlation math. It's an abject lesson in wholesale money supply almost purely in derivative form.

But in the context of the unstable "dollar" environment of 2014 and 2015, there is a more general determination to be uncovered. The reason the CIO unit got stuck in IG9 in the first place was indelibly basic. I'll let JP Morgan's internal report speak for itself:

"In late 2011, CIO considered making significant changes to the Synthetic Credit Portfolio. In particular, it focused on both reducing the Synthetic Credit Portfolio, and as explained afterwards by CIO, moving it to a more credit-neutral position. There were two principal reasons for this. First, senior Firm management had directed that CIO - along with the lines of business - reduce its use of RWA. Second, both senior Firm management and CIO management were becoming more optimistic about the general direction of the global economy, and CIO management believed that macro credit protection was therefore less necessary." [emphasis added]

It was, at its heart, a bet on the recovery - and the firm got crushed, spectacularly, in doing so. This has been the persistent theme of actual financial condition, over and over and over again. Economists have been more than promising this eventuality, they have made it their central case to all other exclusion. Banks have taken that backward application to actual trading and wholesale money propositions, and have been burned repeatedly for their trouble. That has been especially the case in 2013 and thereafter, no longer so assured by the perceptions that QE is something other than an outright lie (inert bank reserves, you will notice, play absolutely no role in any of this).

Rather than perform a steady withdrawal, of course, this retreat from FICC, "bond trading" or money dealing has been lumpy and uneven. The first of that occurred right around November 20, 2013, and then again in June and July last year. As I have stated and presented before, in raw terms of gross notional derivative exposures reported by each bank, the declines are simply astounding. For Morgan Stanley, the bank jumped on QE2 in interest rate swaps, increasing its balance sheet exposure (in terms of gross notionals) by more than 25% just in Q1 2011, from $32.5 trillion to $41.3 trillion - only to see that pared back substantially once the crisis of 2011 kicked into gear.

Not to be deterred, Morgan Stanley did it again with QE3 and QE4, going from $35.8 trillion in the fourth quarter of 2012 to $41.1 trillion by Q3 2013 (just before the events of November 20). It has been almost straight downhill from that point, with the firm reporting just $23.7 trillion in interest rate swaps gross for Q3 2015; a reduction of 42% since that point, and 47% since the ultimate peak at the onset of the 2011 wholesale bank events. JP Morgan has been only slightly less enthusiastic for its derivative retreat, having pared just less than 40% of its IR swaps exposures since the middle of 2012 (from $67 trillion to $37.3 trillion as of Q3 2015).

This doesn't just answer why swap spreads would be so negative of late, and so widespread in that condition, it answers a great deal about the "sudden" accumulation of "recessions" spreading across the domestic and global economy. The incidence of "deflation" pressures and worries all over the world are likewise consistent with this agitated, not "strong", dollar. It is quite simply a "money supply" issue only one that doesn't contain what is conventionally assumed of money. Banks, the true nature of wholesale money, are leaving the business and lately they can't do so fast enough. Central banks cannot pick up the slack because they first don't believe in it, starting backwards as they do not just about the recovery but also what money is to them, and second are incapable. They cannot supply what is in shortage; wholesale "dollars" particularly in the dark leverage components of FICC that sustain the eurodollar's steadier states.

It has come to this because these same banks, at various points in the recent past, had the great burden of trying to wager on the recovery and economy that traditional, now anachronistic, economics forecasts from its simplified math and ancient operative abilities. In a credit-based reserve currency regime you cannot expect economic expansion where no institution wants to be that credit base.

What we are left with is the Aristotelian proposition whereby Janet Yellen claims the economic equivalent of heavier objects falling faster than lighter ones. She is certain that the essence of this economy is strong, and further that she and her predecessors have made it so through nothing more than the bland act of acting. Thus, anything that is observed to deviate from that "fact" is to be set aside as all that matters is her determination of essence. Money dealers, which are the actual weight behind the financialized economy, have tried that out too many times to repeat; they will do so no more and experimentally establish the foundation for what we actually see.

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

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