It Takes Great Effort to Be Economically Inept

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In early November last year, the world seemed to be heading back in the right direction. After the "unexpected" nasty events of August, all that seemed to have passed into forgotten memory. The FOMC even declared as much at its October meeting, setting the stage for the December change in policy communication (it wasn't a rate hike in any meaningful sense). The S&P 500 had rebounded so sharply that it was threatening to reach new highs.

On November 2, the index traded above the 2,100 level for the first time since August 17, a span of only three and a half months but with a wide gulf in systemic condition in between. The following day, stocks reached what would be their local peak where upon they only descended again as if gravity itself were latched. The quick nature of the volatile moves through August and September appeared (to the mainstream) confirmation of nothing more than an anomaly, but lingering doubts prevented complete, unconditional embrace of that interpretation.

The Chinese yuan exchange rate to the US dollar had tracked in astonishingly (to the mainstream) similar fashion to US stocks. On August 10, CNY plunged in what so many in the media and economics tried to classify as some kind of "stimulus" to restart China's exports. Two weeks later, global markets crashed suggesting that there was much more going on.

Also on November 2, CNY "traded" to its highest point at 6.318. That was a significant reversal on its own terms given that it had pushed as low as 6.4122 on August 25 - the very day, not coincidentally, that stocks had bottomed. For the next almost three months (a measure of time that we find repeating constantly) in general terms CNY and US (global) stocks moved upward together. On November 4, however, yuan dropped rather sharply while stocks resumed their at-first slow descent into the next "anomaly."

Over in Japan, the yen (JPY) was behaving far differently. Continuing on an almost unbroken "devaluation" due to all sorts of distortions, the yen had traded to less than 125 to the dollar in early June. There was some volatility over the next few months, but by August 19 it was still below 124. As the world crashed into August lows, however, the yen shot sharply upward all the way past 118 on August 24. Further, it would stick around 120 all the way into early November.

Where stocks and CNY had reversed at that time, JPY found a sudden burst of "devaluation" to once more trade less than 124 on November 17. Then, as if hit with a hammer, it started a hard reversal that was coincident first to a massive blowup in US junk debt. By January 8, 2016, just as global liquidation was once again wreaking widespread havoc, JPY was past 117; it was trading near 116 on January 20 when whispers of Japanese NIRP grew loudest, confirmed only a short time later.

In response to NIRP yen initially dropped against the dollar comforting the mainstream sense of how these things "should" work. It didn't last, however, as though JPY was below 121 again on February 2, it would closely follow in inverse the last leg of global liquidations through the bottom on February 11. That day, JPY had appreciated all the way into the 111's even though the Bank of Japan had become active once again and was threatening still more.

Everything that orthodoxy declares about currency movements was wrong in the yen since November (and more than that, but the narrow focus here is enough). Currency movements are supposed to be determined by central bank or government action particularly as they relate to interest rate differentials (real or nominal). Yet, even though the Federal Reserve had increased US rates on December 16 and the Bank of Japan offered contrarily more "stimulus" at the end of January, it was the dollar that was falling as the yen rose. And all of that was matched perfectly to global liquidations in almost every market imaginable.

It was third time in only a year that a major central bank was held powerless as its currency defied its every practice and expectation. There was the Swiss in January 2015 and then the Chinese in August in terrifyingly spectacular fashion. They all share the same affliction - the global dollar short.

Knowing that both the Chinese and Japanese systems are "short" the "dollar" makes this review all the more confusing. After all, we know that these currency movements match up well with what we observe of "global turmoil" but they did so in seemingly opposite directions - the yuan drops while the yen rises even though both are short in "dollars." My short answer to that apparent contradiction is that it is not a contradiction at all but further and frustrating granularity and nuance. For those who may be content to remain around the domain of sanity, the difference in direction is far less important than the volatility itself. In other words, once a currency is grasped by the "dollar's" disruption and begins moving it doesn't matter which way, it only matters that it does.

Floating currencies were supposed to be the ultimate answer to the rigidity of the gold age when in fact stability is still the desired operative condition in any age. What floating currencies have done is instead interjected different ways with which instability is manifested and (badly) managed. The ultimate currency response to instability is determined by the method of its wholesale reality.

Though both China and Japan are "short" the "dollar", each of them has done so in drastically different ways. The PBOC, supposedly the source of all yuan in the growing Chinese financial dominion, is powerless without its foreign "reserves." As of its latest update for the month of April 2016, the PBOC declares total balance sheet assets of RMB 32.909 trillion. Of those, RMB 24.6 trillion are forex assets of various unknown forms. That means that the entire Chinese monetary system is based on foreign wholesale money - three quarters of all PBOC assets.

Therefore, having a "dollar" problem affects and afflicts directly internal yuan conditions as if the Chinese are "short" the "dollar" not once but twice (maybe three times; once at the PBOC; twice at the domestic banking; a third at the non-financial corporate level for mercantile trade). The Japanese, by contrast, share no such base vulnerability. The yen is the yen. Thus, the nature of the Japanese "dollar short" is immediately different and, you could say, opposite that of China.

How that leads to rising yen comparable in disruption to falling yuan is not at all certain and obvious, but we can reasonably speculate as to the difference starting from yen. The mainstream version of the yen carry trade proposes that a financial agent borrows cheap yen and invests in dollar assets - interest rate and return differentials amounting to nearly arbitrage. Japanese banks, however, have no need of borrowing yen since they have so many of them to begin with; so much so that the Bank of Japan under NIRP is essentially trying to penalize large Japanese banks for not doing anything domestic with them.

The fact that Japanese banks are not deploying the byproducts of BoJ QQE in Japan does not mean the otherwise inert yen liabilities are not being used as something else. Again, in the carry trade format Japanese banks hold all the yen they could possibly ever need, what they lack is the swap into "dollars" that the eurodollar system provides. Where those "dollars" go after the swap is also far less than straight forward, especially as it seems that so many of them ended up in China (demonstrating once more that everything in the eurodollar is somehow connected to everything else).

The issue about yen is not so much the "dollar short" itself but rather the means by which it takes place. A cross currency basis swap with Japanese banks does not disturb the currency exchange rate because the basis swap agrees on an exchange both upfront and at maturity. Given that framework, there is and should be no direct effect upon the currency of either JPY or USD. The effect shows up in rollovers, or lack of them.

Unlike what is taught in textbooks, swaps aren't just matched to specific purposes as banks, in particular, are running books or desks as portfolios. Thus, funding for a book of trades can be spread across different methods and maturities. That means rollovers.

If Japanese banks were heavily into obtaining dollars via basis swaps especially right after QQE, they would have determined not just the rate of both legs of the swaps but likely factored the expected future direction of JPY. Since it was on a multi-year down-trend that QQE was thought to only fortify, there was undoubtedly considerations as to what the future state of rollover costs would be - addressed directly through further means and hedging like swaptions or, in the likely case of JPY at that time, intentionally left completely unhedged. It's not as absurd as it sounds when something becomes entrenched conventional wisdom; once something happens (like JPY devaluation) that is expected to happen it is not uncommon for rational humans to simply believe it will always happen. Belgian bank Dexia was bailed out for a second time in October 2011 because it was funding a "carry trade" via total return swaps that essentially shorted German bunds. Because they never thought that interest rates would decline and do so as much as they did, the bank was totally exposed when the (modeled) impossible did happen.

If Japanese banks that had been "short" the "dollar" in the Japanese way suddenly found that they no longer wished to continue, turning it around isn't quite so easy and normal. We don't really have to speculate all that much as to why they might have had second thoughts, especially if they were heavily exposed, via "dollars", to China just as China started to become the top global newsmaker for all the wrong reasons. Because Japanese banks were not just holding dollars or dollar assets the entire time they had been engaged in cross currency swaps, they would have to source them somewhere else to get out. It could mean further short-term borrowing in repo (connections between Japan and repo are very well established of late) but it could also mean more basis swaps from the other side.

As a bank seeking to remove its "dollar" exposure and needing to find "dollars" to do so, you might pay a premium on the next currency swap to get out of the prior one. In terms of cross currency basis swaps, that would mean paying a compressed or even negative spread to LIBOR (the dollar leg). As you become more desperate to source "dollar" funding, you might even bid the basis swap highly negative. Again, as noted above, the contracting of basis swaps does not move the currency - but it does attract follow-on trades that would.

Seeing a highly negative basis swap as a huge opportunity to take advantage of the Japanese version of the "dollar" short, it suddenly appears as if "capital" is flowing into Japan and indeed that may actually be the case. It would be as if the carry trade reverses including the relative "value" of being on one side or the other. That much has been confirmed by traditional accounts of late, where Japan precipitously has "benefited" from great foreign interest in Japanese assets.

This increased "demand" for Japanese financial assets turns the negative basis swap rate into a rising yen. If Japanese banks had never hedged against a serious shift from further devaluation into sustained and significant appreciation, and there is good reason to believe that they didn't, then that would only amplify their desperation to get out of the "dollar short", making for an even more negative basis rate and increased external "demand" for yen entry. At some point, it becomes self-reinforcing to the point that the yen "market" ignores even the Bank of Japan and its NIRP insanity (which makes it all worse, but that is another story).

The eurodollar being a system more than a currency, it is appropriate to think about it in terms of the global reserve currency. More specifically, however, the eurodollar standard is really a swap standard and has been for a very long time. You can go back and research into the 1960's to appreciate just how much it had already become a system purely of cash flow exchanges rather than cash. If I was forced to identify what a eurodollar actually was, I would have to say it is almost always some kind of swap.

Getting into wholesale finance and the eurodollar or swap standard amounts to a paradigm shift from traditional beliefs on currency and global finance. It is in many ways like the difference between traditional physics and quantum physics. There is an intuitive and very real appreciation for traditional physics as it is the world of observation and experience. Quantum physics defies easy grasp, setting up an utterly strange world of, for laypeople, seeming incomprehensible babble.

So it is with international currency regimes; traditional economics is intuitive and easy to grasp especially when it seems "capital flows" are literally movements of physical objects. Wholesale currency is like quantum physics in that it is almost indefinable to the outside world of tangible experience. There are not armored cars moving around actual dollars or gold bars, only ledger balances on computer screens that we are not nor ever will be privy to. Furthermore, as a condition of the swap being the primary agent, it isn't ledger balances now that so much effect general global condition but the various indications for future ledger balances. It is a hidden world of inference and nuance, a level of complexity that is its own barrier not the least of which because it doesn't seem to be real or even possible.

Part of that disbelief stems from the behavior of orthodox economists and central bankers. They have held fast to the traditional view of "floating currencies" as if there were any currency traded to float. Describing this "quantum" money sounds immediately preposterous to anyone not familiar. How can the world be running on a virtual currency that nobody has ever heard of and where the world's central banks vehemently deny it exists? It's a crazy sounding idea all its own, but stark raving mad when you further assert that it has been that way for half a century.

As any good court case, if you are going to make an indictable claim you better provide motive. In the circumstance of central banker denial of the eurodollar system and its sometimes indescribable facets, it is quite easy to do so. The entirety of activism in monetary policy is predicated on one solemn belief - quantity theory. If a central bank means to control the economy by manipulating monetary inputs, it has to have reliability and defined relationships. This is not optional, and it has been put forth as if proven. The foundation of a "rules based" paradigm for monetary policy is exactitude. That means being able to not just define correlations but even more basic needs of measurement.

The eurodollar system obliterates quantity theory and thus activism. You can't measure money if you can't see it or even define it. How does one explain money where yuan goes down, yen goes up and both together indicate "dollar?" If you can't define money then all claims to being able to predictably manipulate the economy are invalid. Central banks have entirely political reasons for denying what has become obvious because what is now (more) obvious leaves nothing left to their self-assumed title to political power.

The Federal Reserve promised authoritative results from its quantitative easing. The term itself directly evokes exactly this philosophy of monetary precision - quantitative. Instead, the FOMC was "forced" by lack of positive outcomes to do four of them; and still nobody can quite find any detectible imprint. It's as if four trillion dollars in balance sheet expansion just disappeared, swallowed up by a monetary world far greater than what the Fed could ever offer. From that point of view, reality, it starts to become clearer just whose version of currency is crazy.

I purposefully added the whole crisis to post-crisis ballooning in the Fed's balance sheet in that color. No matter what the Fed has done starting all the way back in August 2007, it never seems to make much if any difference. They supposedly unleashed massive "stimulus" and accommodation all throughout the crisis and the system and economy crashed anyway. The shift to QE was supposed to shake off that failure and at least deliver the recovery - only now we find increasingly that what little recovery there might have been was more so statistical mirage than actual advance.

Failure of the traditional doctrine starts where the Japanese yen rises and Chinese yuan drops into the same mix of global instability. This old order is falling away more rapidly now, forced to by necessity. When the PBOC fixed CNY on August 10 in drastic fashion, the last vestiges of quantity theory were put forth in again attempting to "explain" it as intentional "stimulus" devaluation - the first step in the orthodox playbook to restart exports. That textbook makes no consideration, however, for the possibility that changing the relative value of a currency means nothing when it occurs because the world's true global currency is simply disappearing. What good are cheaper exports to a world without any money to buy them?

The global crash that followed two weeks after the CNY drop should have been enough to prove all this. That it happened again in January leaves now no doubt except by those politically and ideologically committed to a world that doesn't exist and hasn't for fifty years. With CNY dropping yet again, and right on schedule I will add, I suspect we might be "treated" with a third round of evidence for good measure. It is not coincidence that orthodox monetarists were taken for geniuses all the while the eurodollar standard was expanding, qualitatively as well as quantitatively, and are now increasingly (and rightfully) viewed as floundering idiots who can't do anything right as it falls apart. You don't just lose decades (economically speaking); it takes great effort to be so inept.

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

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