Markets Aren't Cooperating With the Fed's Rate Hike

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When the FOMC voted on December 16 to raise rates, they did so with reservations, some expressed publicly, that maybe they didn't really have the ability to do it. There is a reason that we refer to money markets in the plural, since there are, as the "s" at the end indicates, more than one. At one point in financial history, they all worked very well together, though the manner in which that harmony developed appears entirely lost on policymakers. They just assumed and continued to do so; they still do today, though with much less certainty attached.

In the little more than two weeks since the FOMC's move, money markets have not behaved. The effective federal funds rate had traded within the intended corridor of monetary policy - until yesterday. The fact that policy "needs" a corridor at all gives you great insight into the grey area in which the Fed is determined to investigate; the "s" in money markets. Various tools, from IOER to reverse repos (RRP) and more, are designed to build a durable framework with which to completely capture money market behavior, a network of incentives and risk characteristics that are intended to leave nothing to chance. For example, the federal funds rate itself should never trade below the corridor "floor" set by both the RRP and IOER. After all, if there is "too much" liquidity floating around in federal funds that it might sink below the floor, those holding all that liquidity should instead place it alternatively with the Open Market Desk in RRP's or idle on account to receive IOER.

Yet, for all that hardened assumptions about the money markets in theory under heavy Fed influence, as distinct from money market(s) in practice, yesterday the federal funds effective rate traded 12-15 bps for most of the morning; a full 10 bps and more below the "floor" of 25 bps. Given that it was New Year's Eve, and thus the end of the calendar year, it was undoubtedly a function of window dressing as per usual. However, that still does not explain why the corridor failed. Again, the theoretical incentives of IOER and RRP should have still been in place regardless of window dressing proclivities; why lend, unsecured, at 15 bps in federal funds, with all the attending counterparty risk, when you could instead "lend" at 25 bps, secured by UST collateral, with FRBNY and no counterparty risk?

This isn't the first occasion where the corridor has been, let's say, underwhelming. The RRP itself was meant to be a huge influence, and yet since the rate decision it hasn't much moved. There has been no indicative increase in usage despite the fact that private estimates were thinking in the trillions, while the Fed itself made special effort of separately announcing that it would "cap" RRP at the unaccounted for SOMA balance - opening up the whole UST pile in SOMA not already repoed out via foreign accommodations (which is a whole other contradictory mess). In short, expecting big business at the RRP window, the FOMC stated, essentially, it would go to about $2 trillion. Instead, yesterday, in what was the usual year-end window dressing ramp, the RRP "borrowed" just $277 billion. Even if this were just some matter of convenience, as in banks (non-banks) not wishing to go through the program for just one or two days, that isn't supposed to be a consideration, either; these are supposed to be frictionless substitutes.

GC repo rates have traded consistently above the corridor, with the MBS GC rate (at least what is produced by DTCC from exchange-traded repo; leaving, admittedly, a great deal of actual volume unknown but not likely to be all that different) shooting up as a high as 60 bps! Again, incentives across money markets play a role here, as there is no clear reason (in theory) why a money market borrower would pay 55 bps while posting UST collateral when they could (in theory) borrow unsecured at 36 bps in federal funds.

Even that last part has been somewhat in doubt, as the federal funds effective rate is really an average of trades that take place dispersed about a truly unpredictable range. Monetary policy and interest rate targeting of federal funds is all about just averages, as policy looks not just at an average rate to define market conditions but spread across "maintenance periods." In the maintenance period following the rate hike, the intraday highs of actual federal funds have been, at the very least, interesting. On December 24, the high trade was 88 bps, a very unusual dispersion compared to the more deadened and steady deviations recorded for the past few years. On Monday, the high was back to 63 bps, which would be closer to prior levels of experience, but back at 68 bps Tuesday.

While it has only been two weeks and it is entirely possible that money markets are just trying to find their way in something of a beta test of non-ZIRP operation, there are several indications that money markets remain steadfast to that plural. In addition to foreign RRP in heavy, heavy usage, T-bill rates at especially 3-month and 4-week maturities are conspicuously shallow, thus pointing directly to a collateral problem (which the RRP was supposed to address directly) and perhaps a foreign one at that. What was supposed to be an easy command, as monetary policy is always described, is much more difficult and imposing in practice - a commentary that extends much too far now in history. I am reminded of what Milton Friedman and Anna Schwartz wrote in 1963 in their seminal monetary book, A Monetary History, which stands as something of a bible for modern monetarist practice.

In Chapter 6, Footnote 13, Friedman and Schwartz write:

"It is a natural human tendency to take credit for good outcomes and seek to avoid blame for bad. One amusing dividend from reading through the annual reports of the Federal Reserve Board seriatim is the sharpness of the cyclical pattern in the potency attributed to the System. In years of prosperity, monetary policy is said to be a potent instrument, the skillful handling of which deserves credit for the favorable course of events; in years of adversity, monetary policy is said to have little leeway but s largely the consequence of other forces, and it was only the skillful handling of the exceedingly limited powers available that prevented conditions from being worse."

While the authors were writing about the Federal Reserve's early years in the 1920's, which they call its "high tide" no less, that passage practically begs to be assigned and recycled to central bankers in 2008. It seems to be an ironclad law of monetarism throughout the whole of the centralized setup. Ben Bernanke was a hero, supposedly, because he saved us all from a much worse fate with very limited tools at his disposal. Of course, that is not what was proclaimed of monetary policy before 2007 and 2008, a sharp divide in chronological terms that echoes Friedman's main point (which I will get to later).

To think it the sole deficiency of the Fed system, however, would be a mistake. In July 2009, the ECB dedicated a good portion of its Monthly Bulletin to revisiting "all" that it had done over the prior nearly two years going back to August 2007. And indeed, there is a clue contained in all this post hoc back slapping as almost from the outset the ECB describes the peculiarity. Writing, "The euro money market was strongly affected by the tensions originating in the US sub-prime mortgage market on 9 August 2007, when rumours about large exposures of some European banks affected their ability to obtain liquidity in the US dollar market and subsequently led to a spike in euro money market interest rates," the ECB intimates the very money markets (plural) effect that we are revisiting about today. What made "European banks" problematic for euro-denominated liquidity was not just the credit risk embedded in the "US sub-prime mortgage market" but "their ability to obtain liquidity in the US dollar market." There were, in other words, transmission mechanisms (contagion, as it was called) among various money markets, beyond just dollars, that had already gained the potential to overwhelm "whatever it is" that kept the various money market fragments working together (globally).

The essay spends a lot of time detailing the ECB's biggest efforts and programs, which is an understandable reaction on their part given the timing of July 2009. On October 8, 2008, MRO's were switched to a fixed rate tender with full allotment, to satisfy all bank bids at the fixed MRO rate; also on October 8, the interest rate corridor in euros, something that Fed is clearly trying to emulate now, was narrowed for the first time; on October 13 and again on the 15th, the ECB expanded the list of eligible collateral; on October 22, the ratings threshold on eligible collateral was reduced to BBB-, except on certain private label ABS and MBS; on October 30, the fixed rate tender applied to the MRO's were expanded to the LTRO's. Of all those, however, the most important was certainly the complimentary action of October 13, where fixed rate tenders were applied to US dollar operations in the form of repos in to the ECB and dollar swaps out to the Federal Reserve.

Total liquidity provisions which had been a bulging €463 billion in the maintenance period ended October 7, 2008, had surged to €802 billion by October 30, and €860.7 billion by year's end. Again, more importantly, by the end of October the ECB had been "providing" more than half of the Federal Reserve's total FX dollar activities. For European banks, that amounted to $300 billion. The sum total of all that led the ECB to write in July 2009:

"These measures, which have been non-standard in nature, reassured financial market participants that the availability of central bank liquidity was not a reason for concern, and contributed to a return towards stable money market conditions."

The problem with such an assessment, that the ECB had "reassured financial market participants" about central banks actually performing "non-standard" currency elasticity as they were supposed to, is the very troubling calendar situation of all the dates by which that was supposedly accomplished. The first of those, the MRO fixed-rate tender, was undertaken on October 8, 2008 - after the crash. By the most charitable interpretation, the ECB was quite effective only once it was all over, and even that doesn't really describe what happened as though the ECB, as the Fed, were now doing all sorts of "non-standard" and "emergency" (and of dubious legal stature) programs the true end of the whole crisis would not come until March 2009! The Great Recession itself, which was global by then, leaving so very few economies unscathed, would not end until that summer.

Again, Friedman and Schwartz; prior to the crash, central banks declared, emphatically, monetary policy left nothing to worry, but after the crash that was all shifted to heroic efforts that involved great "courage" to throw off the regulatory and conventional restrictions that suddenly abounded in order to save us all from a worse fate. If central bankers were truly so heroic and effective, they would have seen those restrictions ahead of time and had been prepared for them. But classifying this problem as a matter of regulation or just practice is actually a full part of that problem to begin with. It is something much deeper and more significant than that.

We can start to see that in something I have written about QE commentary. Very much like what Milton Friedman and Anna Schwartz were suggesting of the Fed in the 1920's, we see again in the 2010's with regard to the QE's (and the various QE-like programs, that are now fully QE, in Europe): in future tense, monetary policies like ZIRP and QE will be powerful and effective; in past tense, they were disappointing and "unexpectedly" limited. You can practically read their passage quoted above as if it were written directly for the QE age; with one great exception. At least in the 1920's, the power of monetary policy was evident, in the authors' analysis, in actual conditions, or "years of prosperity." We have seen no such thing across the world since August 2007 (and even then what was "prosperity" was more artificial and fleeting, but at least it held the same flavor for most).

Thus, the QE's have a deficiency that is almost entirely new, at least in that any visible upside has (had) been terribly limited to asset prices exclusively. General prosperity has been conspicuously absent; take a look at the political landscape not just here but everywhere, as upheaval and change is demanded almost universally (explaining, relevantly, a great deal about what the PBOC is doing and attempting). Even in markets, for several years now we have been seeing warning after warning that "something" is not quite right. The euro crisis in 2011 was a big one, especially as even the temporary glimpse of recovery potential did not survive it. The 2012 slowdown, globally, that followed pushed all sorts of countermeasures that were not "supposed" to be necessary, and not just QE3 in the US but massive renewed "stimulus" in Europe, Japan, China, Brazil, etc., etc.

Then came the events of 2013, where the world's currency markets seemed to crash; those "crises" now seem quaint by comparison to what we see today. There was the ECB's first negative nominal interest rate in 2014, the "rising dollar", October 15, 2014, the ruble crash that December, junk bonds crashing also in December, the Swiss franc January 15, oil crash concurrent to that, Greece and European bonds this past spring, renewed commodity carnage in early July, the PBOC being blasted out of its obvious intervention in CNY in August, global crashes later that month and continuations of all those right up to the end of the year.

Alongside all that, economic difficulties that looked to be just sluggishness in 2013 now appear in so many places truly frightening and nightmarish. Brazil is in a state where Brazilians are comparing the economy not to the Great Recession but rather the Great Depression. Nobody can find where China might end up and a great deal that suggests they have already taken to hiding it. Canada falls into recession while Japan argues whether the past two years should be classified as separate recessions (more than two). The US suddenly finds a revenue recession leading to a profit recession, a full conflagration in a junk debt bubble likely three times the size of subprime mortgages, followed now by a manufacturing recession and industrial production that figures maybe a whole recession.

And all of it predicted comfortably by the "dollar." As much as economists tried to make the "rising dollar" out to be some "strong dollar" from economies past, the very fact that they did only highlighted this very problem. A truly strong dollar was itself an expression of convertibility, or the distinct lack thereof. If people were satisfied with the general state of economic and financial risk, they would not turn to converting currency into money meaning the dollar would be strong and stable. A rising dollar, such as has been seen in the past nearly two years, is not stable; quite the opposite. The direction of that instability, "rising", merely tells us the general source of the disturbance; how far it has risen, the intensity.

When looking back at that catalog of increasing financial and economic carnage, the pattern should be immediately recognizable to economists as "shrinking" or "tightening" money supply; all the symptoms are there and apparent. It is the classic replay of that condition, as reductions in money supply lead to monetary deflation (commodities and certain markets, including stocks that have, for almost a year and a half, gone, at best, nowhere, and for a great many places have already sunk quite significantly) and depressive economic conditions. To the orthodox economist, however, that just cannot be since ZIRP and QE are both "stimulative" while the latter is sold as "money printing."

That means either the world has taken to an entirely new mode of operation completely different than at any time in recorded history, or economists don't know much about money. It sounds like an amazing charge, the latter, but it is, in fact, not the first time this has happened.

If you go back and read through a great deal of financial and economic literature of the 1970's and early 1980's (not an entertaining process, I'm here to claim, but a very useful one), you will find repeated references to "missing money." In almost every case, that is the very term used suggesting that it was at least something of a solid convention, and therefore contention. There are innumerable academic papers on the subject, so I will only list a few here: "Some Problems of Money Demand", Enzler, Johnson and Paulus, Brookings Papers 1976; "Some Clues in the Case of the Missing Money", Gillian Garcia and Simon Pak, American Economic Review, 1979; "Financial Innovation and the Monetary Aggregates", Pomter, Simpson, Mauskopf, Brookings Papers, 1979; "Defining Money for a Changing Financial System", Wenninger and Sivesind, FRBNY, Spring 1979; "Are RP's Money?", FRBSF Weekly Letter, June 1979.

That last paper explicitly states where all this was coming from, as RP refers to repurchase agreements or repo. In fact, what all this amounted to was an attempt to define and characterize the economy of the Great Inflation as monetary, and monetary beyond that which existed in the 1930's and 1940's. It sounds almost absurd, but that is only because modern perspective has absorbed at least some of the changes in money that occurred in the 1960's and 1970's. The hard part is that economics assumed that those were the last of the monetary and really banking innovations, leaving the decades since totally barren of new forms of financialism and actual money behavior. It is a curious conclusion all its own but especially now with all the radical new inventions in banking and banking operations.

There was a similar flurry of academic searching in the early 2000's, mostly, however, coming from overseas or international organizations like the BIS. Researchers were noticing very strange and new behavior patterns in global markets, including and especially eurodollars funding non-bank activities inside the United States. That wasn't surprising, even to anyone paying attention then, given what had transpired in the late 1990's in banking, from VaR adoption to deregulation and massive consolidation, and then in the early 2000's the ascension of the Gaussian copula as a means to mass produce securitization - which required correlation pricing, something that could only be derived from derivatives markets.

The Federal Reserve responded to all that by discontinuing M3, which contained repo and eurodollars (some of it, anyway, which was the point in ending the aggregate calculation), and referring to some mysterious "global savings glut" as if money was being created traditionally everywhere else but here and then mysteriously transported via some unknown mechanism into London dollar trading. And even then, the Fed, comfortable and confident in its ability to carry out currency elasticity, saw no reason to expect difficulty in assigning and assuring liquidity across money markets (plural).

What is ironic is that the basis of that self-assurance from the point of view of orthodox central bankers is traced directly backward to Friedman and Schwartz essentially defining the monetary paradigm. At its heart, however, the overriding point they were trying to make in unpacking the calamity of the Great Depression was to not forget about money. Generations of economists have assumed that point but only insofar as money hasn't changed since the 1960's. It is an untenable assumption even from the 1970's as money had clearly shifted; but instead, economists assumed that all that "missing money" was really just some expansion in the menu of investment choices.

I'll conclude my commentary on 2015 by pointing out that unbeknownst to pretty much everyone, the Fed has, in addition to ZIRP and QE's the past few years, hugely expanded the reserve requirement for traditional banks; the rules that govern how much vault cash or qualified correspondent account balances a bank needs to hold for its given amount of deposit liabilities. This is the essence of what banking and currency was supposed to be, as what Friedman and Schwartz warned about was the amount of currency, raw currency, that could be drawn upon by regular folks to buy groceries and clothing. Nothing chronicled above has anything to do with that; there is no money in monetary policy, and, as we are finding out still today, no currency in currency elasticity. The fact that central bankers hold to some static outlook on money doesn't make it so.

On January 20, 2007, the low-tranche reserve requirement applied to $43.6 million of total transaction account netting. The next annual change, set for January 1, 2009, placed the low-tranche level at $44.4 million. Since then, the reduction in reserve requirements (by statutory formula) has pushed the low-tranche level up to $110.2 million, effective January 21, 2016. At one point in our history, reserve requirements were not just meaningful they were everything (1937 provides a stark example). Now, they just don't count for anything, barely a footnote on some arcane and ancient regulations that remain in place as if nothing has happened monetarily since the first NOW account showed up.

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

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