The Fed Is Blind to Global Dollar Misery

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Just over a year ago, former Fed Chairman Ben Bernanke published on his Brookings Institution blog a four part series trying to explain why interest rates were so low. We know that was his goal because he titled the group "Why Are Interest Rates So Low." The topic should be somewhat surprising especially for anyone whose attention is legitimately focused elsewhere, depending more on the media for commentary on such matters. For these laypeople, they might expect the answer coming from Mr. Bernanke to be something on the order of, "because I wanted them that way."

It was, after all, what he told the world consistently from QE1 to QE2 and so on through all four of his expansions. Low interest rates were the means for the recovery and QE was the means to achieve them. He even went so far as to justify these redistributionary, directly harmful effects on savers as the only way for them to ever see higher or more normal interest rates again. Without the recovery there would be no normal interest rates, and without QE there would be no recovery.

The problem by April 2015 was that interest rates were generally lower without QE than with it. Since that time, it has only become worse. The 10-year US Treasury bond constant maturity yield (CMT) in early 2012 was trading the 2.00% level. It briefly spiked to about 2.40% that March before trading even lower that summer, getting almost to the 1.30s by July. This was all under the auspices of Operation Twist which formed the policy interim between QE2 and QE3. By the time QE3 (which was to be only MBS purchases) was announced in September 2012, the 10-year CMT yield had jumped back up to around 1.85%. When QE4 (UST purchases) was determined necessary by the FOMC that December, the 10-year was still in that same range.

The early part of 2013 would see the bond trade lower (yield higher) to nearly 2.10% before coming back again to a yield around 1.65% by May 2013 when the word "taper" was first uttered. From there, rates surged higher in what was thought initially to be Bernanke's forecast for recovery and the belated start to interest rate normalization. It would only last until the end of the year, and ever since rates are back down more so to the levels of 2012 before QE3 was ever considered. This has stumped economists, including Mr. Bernanke as he struggles to explain the disparity (though in terms of something economists invented called "term premiums").

"That naturally raises the question of why the term premium has recently fallen by so much. The answer is not obvious. Fed policy doesn't seem to explain the decline, as purchases of Treasuries under the quantitative easing program wound down last year [2014]."

To avoid having to directly confront this "mystery" the term "global turmoil" has increasingly been taken as shorthand. Since last August it has taken on greater emphasis and particularly in relation to monetary policy again. After having delayed through the middle part of 2015 in "raising rates" or altering their communicated policy stance, the FOMC was sure to take no longer than September to finally "lift off." Vice Chairman Stanley Fischer was, as usual, overconfident in speaking on CNBC on August 29 (transcribed and relayed through the New York Times) with the Times adding the qualifier. "Mr. Fischer offered an upbeat assessment of the domestic economy. He described job growth as ‘impressive' and said there had been a ‘pretty strong case' to raise rates in September before the latest round of global turmoil."

The FOMC, of course, did not raise its irrelevant federal funds rate in September. I have not yet seen where the FOMC or any of its members have actually deployed the specific term, but its September 2015 policy statement was more than close enough.

"Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term."

By the Committee's assessment, "global turmoil" had abated enough through the late autumn so that by its December policy meeting it felt justified to at least achieve one symbolic gesture for the year. It made for an odd juxtaposition because turmoil was still rampant in far too many of the places that had been disturbed in August. More specifically, any appearance of calm in October had been worn out in November, especially as the Chinese yuan had begun depreciating again; by the end of that month, something had blown up in junk bonds to the point that several resource firms began outright and public financial restructurings. Swap spreads had only compressed further and more negative in far too many maturities (though there was a slight rebound in early December).

By early January, the verdict was once more "global turmoil." When Janet Yellen spoke to Congress on February 10, she said, "We recognize that these developments may have implications for the outlook," and, "This uncertainty led to increased volatility in global financial markets and, against the background of persistent weakness abroad, exacerbated concerns about the outlook for global growth." The implication of the term and the reference is obvious, as Yellen or any economist or media outlet that uses it is trying to defray blame. It is meant to convey the idea of some unknown outside force that is beyond the control of the mere mortals on the Committee.

This is not the first time we have heard of this mysterious dark financial gravity. In fact, you can find "global turmoil" attached in more than a few of these prior cases. On December 9, 2011, for example, the Wall Street Journal published an article under the headline IMF Official Says Global Turmoil Still Threatens Asia. That date is especially noteworthy in relation to the depths of another possible banking crisis and related central bank funding responses. A year later, after QE3 in the US and Draghi's promise in Europe (and the whispers of coming Abenomics in Japan) the IMF became far less concerned about "global turmoil" or Asia - until 2014 when suddenly and quite "unexpectedly" both were back and combined again.

Even in the depths of crisis, there was this unseen force majeure that was beyond all comprehensiveness of any policy body to cope. In an emergency conference call on January 16, 2009, the FOMC was gathered to discuss the FDIC, Treasury, Federal Reserve "deal" with Bank of America. Not only that, this "deal" (capital injections and use of TARP funds due to "a very large loss that Merrill Lynch declared") had been accelerated at the request of Bank of America so the news was already public by the time the conference call had taken place. What was really on their collective minds was the implications of TBTF and what now seemed like a very real possibility - going beyond forced mergers of Merrill Lynch into BAC, rescuing shadow banks the size of ML, to actually having to rescue BAC or Citigroup.

Bernanke himself said that, "I am not going to draw the line somewhere that involves the failure of a firm the size of Bank of America", declaring, essentially, that as Chairman he was prepared to bail out anybody at any time. Because of that view, he continued, "I don't think we have much choice but to try to work with other parts of the government to prevent a financial meltdown." It was an extremely odd formulation even for an FOMC discussion, which often conform very much to the populist charge that these people live in a bubble. "Prevent a meltdown" is not a justification that should have been on anyone's mind in January 2009 - it had already happened! Perhaps Chairman Bernanke misspoke, leaving out the word "further"; but that, too, would be just as inappropriate because no matter what the Fed did at that point or at any point in the whole of the crisis the "further" meltdown happened anyway, just as it would continue on for almost two months and another liquidation wave beyond the BAC "deal."

Bernanke had the distinctly anti-Midas touch, as no matter what he and the FOMC tried it failed. The reason he was prepared to bail out anything no matter how insignificant or how truly massive and offensive was this "global turmoil" gravity that was beyond his and all orthodox economics' collective grasp. "But for whatever reason, our system is not working the way it should in order to address the crisis in a quick and timely way", he confessed. They had no idea what was really going wrong so their only answer was to do anything or everything; or, as I call it, the fingers crossed strategy.

We can even take this voyage into collective ignorance still further, though before 2008 it was in the opposite direction. The true and very damning companion to "global turmoil" is the equally absurd notion of the "global savings glut." As "global turmoil" adds an unforeseen (by economists) depressive element to the global system and economy, thwarting whatever "stimulus" is added in any location, the "global savings glut" was an uncontrolled financial expansion that kept going and going no matter how much braking effort the maestro himself, Fed Chairman of that time, Alan Greenspan, applied. Appealing again via the federal funds rate, Greenspan started "tightening" in June 2004 only to find very little responding.

In March 2005, Ben Bernanke spoke to economists in Virginia on the topic of this financial mystery. He described it as, "over the past decade a combination of diverse forces has created a significant increase in the global supply of saving-a global saving glut-which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today." One of the reasons he offered was (I'm not making this up) the aging population of the developed world, the mass of retirees "saving" for retirement. Then he noted, without compelling further explanation, the somehow shift in emerging market economies from debtors to creditors. As he said, "I believe that understanding the influence of global factors on the U.S. current account deficit is essential for understanding the effects of the [current account] deficit and for devising policies to address it."

As you would rightfully suspect by all the commentary above, neither he nor his successor ever had any success in "understanding the influence of global factors." In specific cases, EM's never actually turned to creditors as he inferred from his traditional data. The "flow" of "capital" was not capital in any such way, but rather was an enlarging "global dollar short" that was being pushed around the world by the very global, eurodollar banks (shadow banks) that he was prepared to bail out at any cost because he really didn't have any idea what they had done or why they had done it.

It has taken the length of this ongoing crisis saga to truly reveal the full unraveling of the "savings glut", though it has, as you might guess, registered more than a glimpse here and there in the eleven years since Bernanke (and Greenspan, with his "conundrum") floated it. It was thought that the great lesson from the Asian flu of the late 1990's was for EM nations to insure themselves against desperate "capital flows" that might financially threaten again their developing economic systems. That meant two separate strategies, the first as ending any currency peg to the dollar. The second was to accumulate as much foreign "reserves" as practicable.

Almost every country, especially those scorched in 1997 and 1998, did exactly that. They accumulated dollar reserves and floated their currencies, suggesting to the traditional currency view of Bernanke and the rest that they had suddenly become creditors (since their forex holdings largely consisted of US Treasury bonds, notes and even, as China, bills). And in 2008 and really 2009 they ran into the same kinds of problems as the Asian flu anyway. Because that was only temporary, however, and the world seemed to have much bigger problems (especially the "somehow" stunted recovery of the "new normal") it was largely ignored - until taper.

The summer of 2013 was looking to be the final glorious sunset for which QE would ride into as the prototypical Hollywood ending, with Ben Bernanke and his confused coterie finally living up to the hero status that they had largely conferred upon themselves in the baffling events of 2008 and 2009. Deeper financial rifts intruded on that scene, though, including a shocking and seemingly serious currency crisis throughout the EM's no matter how high they had piled their stock of UST's and reserves. While it seemed to have all gone away by the first part of 2014, it was still there under the surface acting especially in the manner (term premiums and nominal interest rates) that so confused Bernanke yet again by April 2015.

The turn to the "rising dollar" in June 2014 made the events of 2013 seem like a minor occurrence. None of the supposed lessons of the Asian flu made any difference at all; the largest stockpile of foreign "reserves" in human history, found in Chinese accounts, was no safeguard against CNY "devaluation." That wasn't the only shock to the mainstream, however, as was found in both August and again this January where CNY "devaluation" very closely correlates to "global turmoil" in the form of global liquidations. In other words, it isn't devaluation at all but still this mysterious force majeure.

China's financial system is deep within the "dollar short" no matter how many trillions it assigns as foreign reserves. What is truly mind blowing and maybe even offensive is that the depth of this synthetic short appears very much related to the scale of those reported "reserves." In other words, it is quite likely that mistaken views on them owing to that original misreading of the Asian flu originally led eurodollar banks to lend and expand credit-based "dollar" activity into these EM's on the notion that each country's stockpile of "reserves" was actually some kind of insurance against "dollar" disruption.

"Even when the idea of China's short is allowed, it is still mistaken under traditional terms (such as ‘hot money') that imply again ‘capital flows.' The wholesale version is far more nuanced and presents not just difficulties in perceptions but alterations in function and thus provides very different implications. For example, in the years just after the Great Recession, financial disparities and structural changes in China led to the growing use of currency swaps to fund international activities inside the country."

I wrote that passage in describing in some detail these stark differences; the specific example I used was the very real trend of multinational corporations borrowing in dollars and then swapping into yuan to fund internal Chinese activities. To traditional accounts, this looks like "capital" flowing into China but it is really not one "short" "dollar" position but two (and maybe even three). On reverse, as has been the case since June 2014, "It looks like ‘capital outflows' because the point of perspective is all from internal China, but at conclusion it all just disappears including the original dollar loan to the multinational (the ‘dollars' don't outflow from China to somewhere else, they exit the swap and are extinguished into the long eurodollar night)."

It is not just a matter of accounting differences; these are functionally and existentially distinct processes. From that perspective we don't see EM economies as creditors at all since their quantities of foreign "reserves" were never dollar insurance but rather a far different projection or estimate of just how "short" each nation's financial system was in relation to the more basic eurodollar system. It was the predicate expansion of the eurodollar system, the true credit-based global reserve currency, that gave these countries that veneer. They (and not just EM's) borrowed and funded in eurodollars first and then recycled only some of that back into what Greenspan and Bernanke were thinking as a "global savings glut."

"Global turmoil", then, is just the opposite where eurodollars are not expanding but contracting; causing everyone "short" to have to cover, essentially, which they simply cannot do, thus greatly expanding the "price" of the "dollar" relative to everything else (including other wholesale expressions) and causing open, global disorder where this reversal is most acute. It has already caused additional economic damage in the form of a global slowdown that continues to slow even where various economies or economic factors are already contracting. The timing of this slowdown is uniform all throughout the world, including three distinct stages that coincide with these turns in global monetary conditions - the last and so far worst is steady contraction under the "rising dollar."

Bernanke was absolutely correct about one thing, as he said in his 2005 speech it was absolutely essential to "understand the influence of global factors." He never did which explains a lot about the last decade or so (and you can go back even further under Greenspan, including his "irrational exuberance" speech that was really about the already confusing shifts in money correlations to the economy). It's an unforgivable omission because "global factors" weren't really that at all, but instead dollars. There was never a global savings glut just as now there isn't some nebulous, equivocating global turmoil; it is and always has been the "dollar", the real reserve currency that policymakers have never shown the slightest interest in discovering. The very central bank charged with managing the dollar never realized, and still doesn't to this day, that it was the transformation of its own currency that caused(s) so much constant mystery, heartache, and now, for as long as conditions remain as they are, continued economic misery. At least they got the "global" part right.

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

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