Credentialed Experts Consistently Reveal Ineptitude

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You would think that after the experience of 2007 Bill Dudley would give it up, or at least become savvy enough to stop being so declarative. At the end of July, a few days after the last FOMC meeting had concluded, Mr. Dudley admonished markets once again for being, in his words, too complacent. The futures markets, federal funds futures specifically, are not giving him and his colleagues enough respect.

"Market expectations, to my eye, derived from federal funds futures prices, which price in no more than one 25 basis-point rate hike through the end of 2017, ... appear to be too complacent."

It has become a habit for him, one which you would have to think actual markets that actually discount information have absorbed. Less than two months earlier, in mid-May, Dudley also made his view plain, exposing his own weaknesses in the process. "If I am convinced that my own forecast is sort of on track - then I think a tightening in the summer, the June, July timeframe is a reasonable expectation." Both June and July FOMC meetings have passed and nary a rate hike (though KC Fed President Esther George is back to dissenting again, she was not joined by Mr. Dudley).

Maybe dollar markets know a bit more about what Bill Dudley will do than Bill Dudley's convictions for "my own forecast"?

It isn't just federal funds futures that are increasingly complacent; "complacent" isn't even the right word for it as global "dollar" markets are downright skeptical. And why shouldn't they be? Setting aside all the bluster that is taken at face value in the mainstream because of nothing more than credentials, funding markets have been right. The world in 2016 is a much darker place than what it was supposed to be according to economists and policymakers like Bill Dudley.

Rather than hear what markets are saying, economists have become petulant. The same day that Dudley made his most recent, and certainly not the last, "complacency" remark, N. Gregory Mankiw, eminent Harvard economist, wrote in the New York Times  how little he thinks of the public. He is confident that in the long run his view on what he calls free trade will prevail, as globalism will be accepted more and more in the future because public attitudes "should move toward the experts."

Right now, however, he admits that "voters clearly aren't listening to economists" on matters like Brexit and beyond. Maybe, like Dudley, experts have been wrong so much and so blatantly there is actually good reason for the growing distrust. As concerns the economy, "they" promised a recovery and delivered nothing like one. Further, the more that fact becomes established the more they harden their views that it can't possibly be true. "Dollar" markets can't conceivably be right that the global economy is getting worse, in the expert view, because Bill Dudley has the right pedigree.

The Washington Post Editorial board wrote just a few days ago that the current "political turbulence" is due to the economy. On that count we could not agree more. But the Post then claims that, like Mankiw, the public is too stupid to realize that the economy isn't really that bad.

"But what if that gloomy picture is obsolete, to the extent it was ever true? According to a growing body of data, real hourly earnings in the United States have been increasing for the past four-plus years. There are even tentative indications that the benefits are accruing to lower-income people who need them most."

Yes, real hourly earnings have been increasing over the past four years, uneven though increasing, but so what? Increasing earnings does not make a recovery, full stop. It has been these kinds of reduced standards that economists have resorted to that only further cement this chasm of suspicion. It has become "expert" opinion that if there is a positive number for any economic account then it immediately equals success. Thus, we are supposed to completely ignore the 15 million or so Americans that have for some unexplained reason not joined the labor force since the last peak because the monthly game of headline payrolls only shows positive numbers. Economists ignore them because they can; the economy itself cannot and it shows.

Even the Washington Post doesn't really believe what it wrote, qualifying it all in the editorial's concluding paragraph.

"In short, things are better for workers than they were but still not as good as they could, or should, be. Productivity growth has been nonexistent in recent months, while labor force participation has remained well below pre-recession levels. The challenge now is to bring more workers into the market, while enhancing their skills, so as to boost overall growth rates and sustain higher real wages on an even broader basis."

In other words, there really is reason for gloom, not the least of which is due to the fact that what they include in their list at the end are very serious economic deficiencies; the very scarcities that non-expert people might be more than a little upset over particularly given the near decade now of constantly being told not to be so gloomy about it. It has become the common refrain, that because these institutionally entrenched are all "experts" they should be allowed innumerable chances to show that positive numbers will, at some apparently unknowable point in the distant future, become what "should be."

It was none other than Milton Friedman who developed the mainstream definition of positive economics, the only hope that the discipline ever had of being taken seriously as a science, that totally refutes the very idea of any economy that "should be." Science is a matter of observation confirming prediction; if the "experts" can't deliver predictable solutions they aren't experts at all - they are ideologues.

Take the immense matter of the dollar, really "dollar." The Federal Reserve is supposed to be the preeminent authority on all things dollar; they, as Bill Dudley seems intent on proving time and again, certainly believe it to their very core. Yet, actual "dollar" markets increasingly disagree with them - again. From eurodollar futures to cross currency basis swaps to repo (global repo at that), all the key components of global "dollar" supply are already highly bearish and getting much more so, uniformly betting against Bill Dudley all over again. Every time he says the Fed wants to raise rates, the implied, market-based forward path of future money rates instead declines. Every time the FOMC reaffirms their expectation for 2% inflation, the 5-year/5-year forward inflation rate, a market-based calculation that used to inform FOMC policy opinion, drops to a new low in comparison only to early 2009.

Because of this ideologically-driven problem of perception, even when the Fed gets it right they get it wrong. Repo markets, in particular, are not supposed to have been so susceptible to such sustained upset and disorder. The FOMC added a reverse repo program (RRP) as part of their "exit" package which functions as an additional outlet of collateral should the market flow of collateral ever become so tight.

But even before that, the rot of subprime MBS has been completely purged from the system. It took complete chaos to accomplish the feat, no thanks to the Fed, but by general count the collateral system should be insulated from the kinds of hoarding that we find again today. It was, however, former Federal Reserve Board Governor Jeremy Stein who explicitly stated this very potential in his February 2013 speech that introduced "reach for yield" into the mainstream.

We commonly associate the idea with its more explicit connotations - low interest rates force investors to take on more risk than they would otherwise in the search for returns. That might not be much of a problem on its own, but if the amount of risk investors take isn't matched by the extra yield or return, then the asymmetry of this basic tenet of finance can be destabilizing in systemic fashion. In the context of February 2013, that meant junk bond yields and spreads compressing to truly unbelievable proportions, as well as stock market valuations stretching in similar rationalizations.

"Reach for yield", however, did not end there, unfortunately. As Governor Stein explained:

"Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be ‘pristine'-that is, it has to be in the form of Treasury securities. However, the insurance company doesn't have any unencumbered Treasury securities available-all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade.

"Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does-say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet."

It is, essentially, the same reason AIG became a powerhouse in securities lending as well as credit default swap writing. Monetary policy, more specifically the failure of it in the long run, creates the very conditions by which the monetary system itself can become even more destabilized and corrupted. It is a self-reinforcing trap made so because "experts" refuse to submit to scientific processes and accountability.

Not only were dealers transforming US corporate junk collateral on behalf of much more than insurance companies, there is every reason to suspect that they, especially foreign banks in the eurodollar system, were also doing so for emerging market debt securities, too. From this perspective, the events of October 15, 2014, as well as the rest of that year, take on an entirely different meaning. All the "experts" say that October 15 was of no concern or lingering consequence, as if a "buying panic" in the US treasury market can be so easily set aside.

From nothing more than two paragraphs of Jeremy Stein's three-year old speech we can more easily determine what happened then and why. The junk bond market, as well as EM debt markets, was suddenly facing a serious reversal for the first time. Because of collateral transformation, we know that to some degree repo financing was being obtained through artificial means, an internal risk transformation that placed more risk upon dealers rather than directly of funding counterparties.

As junk bonds were being repriced, especially in the first two weeks of October 2014, so, too, was this repo collateral chain in exactly the same manner as subprime MBS once was. From September 22, 2014 to October 15, the market value component of the S&P/LSTA Leveraged Loan 100, an index of the most liquid leveraged loan securities and a proxy for overall junk as well as CLO's, fell sharply from 996 to 975. It was not only the biggest downturn in years, more than during the whole summer of 2013, it fell below the entire prior range dating back to the 2011 crisis, thus erasing in short order what might have seemed durable stability in junk.

In repo terms, that would mean any dealer that had accepted junk bonds for collateral transformation was stuck with increasingly dubious paper at terms not at all suited for the situation. As haircuts would have been adjusted in the junk repo legs, it would have led to a disorderly scramble for what Jeremy Stein called "pristine" collateral - US treasuries. And it would have taken place in both legs of the "two-way repo", meaning among dealers as well as their initial counterparties (the insurance company in Stein's example).

In the five weeks at the end of Q3 2014, dealers reported a sharp drop in their net long position in UST coupons as junk bond prices started to fall. That was almost certainly their first response to junk bond repricing and repo adjustments - to substitute their own holdings from inventory. In the first two weeks of October, however, dealer holdings sharply increased as the junk problem got worse, meaning that even dealers had reached their limit of collateral supply and were now looking to replenish for their own books at the same time the rest repo market was left then to fend for itself. The 12 minutes of illiquid buying on October 15, again a "buying panic", clearly had nothing to do with computer trading.

But that is the story that the US Treasury Department, the Federal Reserve, and Bill Dudley's FRBNY have decided will be officially supported without further debate or comment. Nothing meaningful happened that day, the "experts" claim, just a bunch of overly fast computers being even more overly fast.

But as the entire realm of officialdom sought nothing more than to downplay any problems, repo irregularity only grew and spilled over into the great "dollar" beyond. By Thanksgiving, the junk market started to exhibit elements of uncontrolled and self-reinforcing selling and GC repo rates, unsurprisingly, spiked above 20 bps, further out of alignment with federal funds (repo is secured lending, meaning that repo rates should be below unsecured) a condition that had started on October 15, 2014.

By the start of December, unleashed was a global burst of serious illiquidity - oil prices crashed, the Russian ruble fell into crisis, and nominal UST rates, along with the eurodollar futures curve, dropped considerably and very noticeably when the opposite "should" have been occurring. Less than a month later, in January 2015, even the vaunted Swiss National Bank was forcibly removed from pegging the franc to the euro because, as SNB explicitly stated in its press release, "The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar."

As all that was providing relevant background, economists and policymakers were contrarily at the height of their optimism and self-congratulation. Third quarter GDP, the last quarter before the "rising dollar" fully bloomed, had been initially reported as 5% and the headline labor figures suggested, in isolation other than GDP, the arrival of the "best jobs market in decades." Yet, right there in front of them was everything they would need to understand why GDP and the unemployment rate would never live up to their drowning hype: the growing discord, disarray, and, yes, global "dollar" illiquidity. For policymakers, however, it was all too easy to set aside because they still somehow believe they know better about the dollar than anyone trading "dollars."

Even if they wanted to see it all as it really was, ideology would have very likely prevented such realization from attaining reasonable reaction. To admit the repo market dysfunction alone would have been to admit that a major monetary policy program was so ill-designed and ill-conceived it was largely a spectator through everything I just described - the Fed's RRP. As I wrote at the time, on October 1, 2014, two weeks before the "buying panic" in UST's:

"'We don't exactly know how it will work' should be stamped upon every message coming from the policymaking apparatus from this point forward, and then retroactively applied to every message in the age of risk and rate repression. Action in short-term money markets has heated up yet again, and that is not a positive statement toward vital function."

It was the opening paragraph in my contemporary examination of the obvious failure of the RRP to stem collateral inflexibility and illiquidity (collateral itself exhibits moneylike behavior). If I could see it, someone with no advanced degrees or formal economic training, there is absolutely no reason that the entire official apparatus of the Federal Reserve could not - other than intentional blindness due to ideology.

And that is what they would also have had to report in light of Jeremy Stein's February 2013 illumination of essentially these very repo risks under his "reach for yield." A member of their own Committee basically spelled it out for them, chapter and verse, more than a year and a half ahead of time - and policymakers looked the other way. They might claim that they cobbled together the RRP to address the possibility of collateral insufficiency, but long before October 15, 2014, it was clear that the RRP was, as I wrote at the time, nothing but a "fairy tale."

If August 9, 2007, was the date at which the subprime crisis turned into a systemic and irreparable eurodollar break, the date October 15, 2014, is proving its mirror on this side of 2008. To this point, the "dollar" system has only become worse, the dollar "shortage" more widespread and increasingly difficult for global authorities to even try to contain, and the US and global economy has weakened considerably in every measurable facet save the utterly uncorroborated unemployment rate. Even the Establishment Survey has decelerated (on average).

The world's self-professed dollar experts were warned, indeed by one of their own. They did nothing because they believed there was nothing for them to do. It cannot be a surprise that "dollar" markets now actively bet against them and to a remarkable, nearly unthinkable degree. The eurodollar futures curve, the market that so vexed and troubled Bill Dudley in 2007, is shallower, smaller, and more shriveled now than during the panic in 2008 and 2009.

These so-called experts hold on to that title due to nothing more than their credentials and pedigree, pieces of paper that clearly function as art and nothing more. They have earned naught, proving instead ineptitude at every turn, at ever crisis denied and evaded; and that is exactly what rising populism affords them, and why it so offends them, a level of shame and revulsion that they so thoroughly deserve. The public does not recoil from experts, it resents poseurs using the appearance to maintain the unworkable reality we all must continually inhabit so long as they maintain it. The Great Recession, for all it was, was a direct invitation for the experts to prove themselves during our great hour of need. And they did; again and again and again. Like Bill Dudley, they are still doing it today.


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

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