Economists Ignore What They Don't Understand

By Jeffrey Snider

Last week while most people were in the midst of holiday recreation and reflection, the Chinese central bank attempted to deny reality. This was not an effort similar to what we have become quite used to, where whatever monetary office tells us there is a recovery or robust economy when the issue is at best unsettled, and more often than not claimed in direct contradiction to all evidence. The PBOC instead wrote in a blog post that the media were being "irresponsible" for reporting that the onshore CNY exchange rate to the dollar had traded below 7.0 at one narrow point last week.

The Chinese authorities contended instead that the range for the currency on December 28 never left 6.9666 to the downside. And yet, if you review all the data from data providers who are about as reliable as anything in this world, there is a flash crash in CNY just prior to the New York open that day. Bloomberg, for example, shows an almost perfect right triangle, with the right angle at the start of the selling, peaking up nearer to 7.01, and then a gentler but steady retracement taking just over an hour to complete.

This would not have been the first major currency to have crashed in such fashion in recent months. Back in early October, ironically while the Chinese were closed for the week on holiday, the British pound was subjected to a similar flash crash. On October 6, sterling fell by 6.1%, though lasting just two "chaotic" minutes. Commerzbank's head of currency strategy, Ulrich Leuchtmann, attributed such low liquidity to the same factor that everyone looks to whenever something like this goes wrong.

"This is not something you would expect in a half-efficient market. We have a liquidity situation which has eroded massively over the last few years and policy makers have largely ignored it. All the regulation that we have in place, for good reason, has the side-effect that liquidity in the FX market is much more shaky and fluctuating heavily, and we have times when it's extremely low, especially in Asian trading."

Maybe the market appears to be lacking in efficiency because all the "experts" keep looking to Dodd-Frank (or Basel 3) in order to sort out and attempt any explanation. In the FX world, there are few reliable and transparent indications or statistics. Of the few that exist, the Office of Comptroller of the Currency's (OCC) collection on US bank call reports including derivatives might be especially helpful in this case. The main takeaway from those figures is that US banks are and have been shrinking their collective derivative books since around 2011.

That wasn't the case for forex derivatives, however. Like everything else, gross notional derivatives in this category had been rising sharply until 2007, reaching $16.6 trillion at the end of that year. For the next two years, gross notionals remained about the same level, suggesting once more that in terms of eurodollars lack of sustained growth is the same as big problems; in that case global financial panic.

While other classes of derivatives exhibited a tempered recovery thereafter (and only until, again, 2011), forex was the one category of the aggregate "dollar" balance sheet that was partially offsetting the larger withdrawal. By the end of 2011, US banks were reporting $25 trillion gross; by the end of 2014, $33.2 trillion. But there it stopped. In Q1 2015, total gross notionals declined slightly to $32.8 trillion, and the trend has been mostly sideways, lack of sustained expansion since.

In the maelstrom of the early weeks of 2015, there was no shortage of possibilities as to why US banks had suddenly and so harshly reviewed their forex portfolios. The Swiss National Bank had abruptly ended the franc's peg to the euro, and not because the euro was about to be buffeted by balance sheet expansion due to the ECB's impending embrace of full-blown QE, but rather, as the SNB explicitly stated, because of the franc's suddenly tumultuous relation to the dollar.

If a central bank as esteemed and often revered as the Swiss' could be so publicly defeated, then volatility as the most potentially destructive of governing bank dynamics would have to be modeled, traded, and adhered to in very different capacity. It would require, in terms of the dollar, rethinking what the Federal Reserve had actually accomplished with four QE's and a balance sheet of $4.5 trillion. The year 2015 was shaping up to reveal all the ways in which QE was a money printing myth.

The Swiss were, of course, not the only victims. They followed closely the Russians who in December 2014 fell into enormous volatility that resulted in gigantic devaluation. But this was not devaluation in the same way as is thought about and considered in the mainstream. The Russian response to the ruble's fall was unusual only in the context of orthodox theory; from the eurodollar or wholesale perspective, it made the most sense befitting the actual operative framework of global FX.

The Bank of Russia (the Russian central bank) had at the end of October 2014 begun to offer FX "repos" in both dollars and euros, backed by the then $100 billion in accumulated UST's and other assorted dollar-denominated assets in Russia's custody. The initial term for the one-week tenders was LIBOR + 200 bps; + 225 bps for the 28-day maturity. Less than a week later, the premiums were cut to LIBOR + 150 bps for both the 1-week and 28-day tenors, and an additional auction for 12-month funding was introduced at the same premium. On December 4, 2014, just as the ruble was getting pounded the most, all auctions were reduced to LIBOR + 50 bps.

Unlike most central banks, the Russians were very open about their reasons, stating unequivocally they were forced into it by, "restricted access of Russian companies and banks to foreign financial markets." The timing of this restriction as well as the format of the central bank response (FX repos) does more than hint at the central problem, a "dollar" shortage. Recall that on October 15, 2014, just two weeks before the Russians were moved to FX deployment, global markets were rocked by a "buying panic" flash crash in the US Treasury market. Then, as now, it was blamed on "regulations" as well as, laughably, computers.

On the occasion of that event's first anniversary, on October 16, 2015, in light of the official whitewash released several months earlier, I wrote:

While downplaying what liquidity is, the report hijacks the whole intention. Liquidity is not what there is today, or what you expect tomorrow, but what any system can deliver at its worst moment, much deeper than being able to "continuously transact" but rather being able to transact at non-disruptive rates and prices. The events of last October 15 qualify entirely as "illiquid."

Stocks were sold off hard in the days surrounding it, while credit markets were suddenly and in many places off limits to any trades even in moderate size. Two weeks later, the Bank of Russia was offering emergency dollars to its banks, all the while economists here, Russia, Switzerland, China, etc., were enthralled by the global recovery that they were so sure was at that point just about to take off.

As the Swiss National Bank followed the Bank of Russia, so, too, would the People's Bank of China. The world hasn't been the same since; a change in circumstances that has applied equally if not more so to central banks themselves. The entire idea of global recovery has been redefined since the PBOC was shattered by CNY instability on August 10, 2015; an "unexpected" crash in the currency that the PBOC couldn't possibly that time deny. No more are monetary officials looking to full recovery, or even a partial one. This is it, the one we have now that has led to social and political upheaval across continents is accepted by authorities as good as it will get.

This was not "unexpected" as the mainstream will have you believe, as it was an outcome judged more and more likely by several key markets including that of US Treasury securities. The "buying panic" of October 15, 2014, was not a one-off but a culmination of sorts. Like the eurodollar curve (that turned first in early September 2013), the US Treasury yield curve had begun to flatten as far back as November 20, 2013 (and whatever it was that happened in FX and IR swaps that day). All throughout 2014, including the early days of the CNY reverse the mainstream likewise could not figure out, preferring instead to defer to the PBOC as surely an intentional policy directive, the UST curve became only more and more bearish. No matter how low the unemployment rate became in the US, the yield curve went lower.

Economists and policymakers have had a tortured history with the yield curve, much like eurodollar futures. They have tried for decades to understand it, but only on their terms. Like everything else in finance and money, if it isn't a regression then to economists it is a complete mystery. In 1977, Milton Friedman urged that since this was the condition for their study, serious economists would need to use parsimonious models to try to extract "useful" data. If they weren't going to truly understand it in the real world, they may as well economize for their statistical models (Positive Economics).

Orthodox literature ascribes the yield curve to "unobservable" factors, meaning that despite almost a hundred years of trying to compartmentalize interest rates into neat little discrete pieces they couldn't really do it. In June 2003, a truly momentous time in US monetary policy history, Tao Wu writing for the FRBSF admitted:

"Various models have been developed and estimated to characterize the movement of these unobservable factors and thereby that of the yield curve by financial economists and bond traders in asset-pricing exercises. Few of these models, however, provide any insight about what these factors are, about the identification of the underlying forces that drive their movements, or about their responses to macroeconomic variables. Yet these issues are of most interest to central bankers and macroeconomists."

After spending some good deal of effort on the statistics, Wu finally concedes, "it is difficult to believe that the structure of the macroeconomy has little effect on long-term interest rates or on the level of the yield curve." The implications are severe, as witnessed in that period after 2013. Ignoring the yield curve altogether, economists were making a crucial mistake in their analysis, relying instead on an unemployment rate (or stock prices) that was at best by then a partial account of the economy. They did so because they viewed QE as unquestionably "stimulus", meaning a monetary increase.

The 5s10s, by contrast, that is, the difference in yield between the 5-year Treasury Note and the 10-year Treasury Note, topped out in the brief "reflation" euphoria of mid-2013 at just less than 140 bps. That crucial part of the curve, the belly, had dropped below 100 bps as early as March 27, 2014, just as the Chinese currency reversal was becoming more of a sustained "mystery." By October 2014, the curve was down into the 70's. On December 3, 2014, it was 68 bps and while the Bank of Russia was struggling to contain external funding for its own banks the 5s10s dropped all the way to 50 bps by Christmas.

Milton Friedman had argued more than a half century earlier that money supply needed to be stable and predictable. He suggested that it should grow steadily at a rate of 3% to 5% per year to be consistent with empirical models he had developed along with Anna Schwartz. In 1960, he wrote, "to judge from this evidence, a rate of increase of 3 to 5 percent per year might be expected to correspond with a roughly stable price level for this particular concept of money." Unlike most economists, Friedman had recognized the idea of money as far from straightforward as it was (and remains) so often treated.

In this specific paper, he argued that M2 would be the proximate target for money growth because by then it was clear that, "there is a continuum of assets possessing in various degrees the qualities we attribute to the ideal construct of ‘money' and hence there is no unique way to draw a line separating ‘money' from ‘near-moneys'." Though he had settled on M2, a decade or so later even M2 was being questioned for its sudden lack of comprehensiveness in Friedman's definitional terms.

In December 1974, Charlie Coombs, Special Manager for the Open Market Committee, told the FOMC that M1 was at that time already obsolete, and while M2 might have to become the new focus they should already be searching for its replacement, a new M3 (not the one that the designation later became). Noting the role of technology and communications in this evolution, though quaint to our social media, 21st century ears, Coombs warned money evolution was important to consider, "especially because of the participation of nonbank thrift institutions in money transfer activities. Some of those institutions were offering 5-1/4 per cent on time accounts from which funds could be transferred into a demand deposit by making a telephone call."

What would be a stable money supply in this modern sense, particularly given a world where monetary conditions can shift and change in a matter of microseconds? There would never be an official answer, as policy shifted away from money and toward generic "demand" for it. The result was interest rate targeting that was never, even to its proponents, a completely sufficient shortcut. Alan Greenspan, as I have chronicled on far too many occasions, spent the better part of the 1990's lamenting the further breakdown of money. The Great Inflation was not just an economic event, nor was it just about the last, tortured break from gold in 1971.

The ECB, of all central banks, had come closest to trying to put into practice Milton Friedman's ideals for monetary stability. During the 2000's, the new continent-wide central bank adopted a two-pillar approach designed to assess on an ongoing basis the risks to price stability. One was economic analysis, the other money. As to the second pillar, the ECB assigned a 4.5% reference for M3 growth so as to define what it considered the "norm."

The relationship between money growth and inflation, defined as the change in HICP per annum, only further degraded as the decade progressed. In late 2003, for example, M3 growth had surged to more than 9%, yet the HICP was still largely around 2%. From 2004 through early 2008, M3 growth would only accelerate but it wasn't until mid-2007 that inflation began to likewise speed up even though by then money growth was above 10% and heading towards a max of 12%.

In November 2006, the ECB initiated a conference where "leading experts" in monetary policy and affairs were asked to present papers (always academic papers) to address what to do given the situation. German newspaper Handelsblatt reported at the time:

"The ECB's staff presented a paper in which the staff presented some hitherto unpublished information about the development of monetary analysis within the ECB. The paper contained a comparison of the accuracy, bias and volatility of inflation forecasts derived from monetary and other indicators...They stressed that the ECB had found money demand not to be stable and had consequently downgraded the role of money demand functions in its analysis."

Having long ago dismissed money supply, the ECB was then stripped of money demand as a factor for monetary policy right before the biggest monetary event since the Great Depression. They were not alone in this condition. If it has seemed like central banks are just making it up as they go, it is because they have been. Friedman argued for a rules-based approach tied specifically to money; policymakers over the years decided they couldn't even define it so instead they would concentrate in other more questionable areas. The results have been predictably awful, and getting more so.

It is worth pointing out at this juncture that yield curves in many places across the developed world were contemporarily warning about what was to come. The ECB in mid-2008, remember, was more concerned about spiraling inflation than chaotic monetary conditions so that by the time they hiked rates in June 2008 it was already near catastrophic break that caught them totally by surprise (even though it was largely European banks at issue). The German bund curve, for example, by the end of 2006 was almost perfectly flat. The 1-year bund yielded 3.85%, and it wasn't until the 15-year maturity that yields were above 4%. By August 2007, the curve was mildly inverted; by February 2008, seriously so.

The defining mantra for the modern economist appears to be "that which we do not understand will not in any way be considered." While you might be able to get away with operating in such a manner in certain places, especially government work, for economics the catalog of "that which we do not understand" is exceedingly large and, as Tao Wu pointed out with regard to the yield curve, somehow still "of most interest to central bankers and macroeconomists." Thus, what Economics (capital "E") has become is the apex of trivia defined to the nth variable often by sometimes really beautiful mathematics, and simultaneously barren on all the knowledge of which the public holds by reputation alone especially central bankers in high regard (though now, finally, more variable in that effect after 2014).

The overnight rate for offshore RMB funds in Hong Kong was a chilling 38.335% yesterday, the one-week rate no better at 17.55%. This is, of course, a repeat of last year when supposedly the PBOC was after "speculators" betting against CNY by going to Hong Kong to get around onshore restrictions. Unlike last year, however, HIBOR (CNH) rates have been in this condition for months now, and yet the PBOC doesn't seem able to quash the "speculation." From this view, you can appreciate somewhat why Chinese officials would be so keen on denying the reality of currency trading when it doesn't look so good. For three years they have been engaged with these same tendencies and often the same proportions with no luck at fostering the stable currency that is their stated policy.

If the Chinese can't steady their own Chinese currency, then what are we really talking about? The lack of economic growth as a global problem is tied directly to unstable money, an observation that characterizes too well the last (few) decade(s). Forex derivatives have stopped expanding (and negative cross currency basis swap premiums keep sinking to more record negatives) on bank balance sheets because banks have been made to realize just how little central banks can actually do, in no small part from what little they actually know.

In the past few months, fewer people seem to care because the latest "reflation" craze has swept across the landscape. Never mind that the last three (including 2007 to mid-2008) weren't ever actual reflation, just the mistaken expectations for it, and maybe because of that the current wave isn't even as robust as it may seem. Credit and funding markets this time are nowhere near as enthusiastic as the often breathless commentary about it. Even the FOMC is far (FAR) more subdued in their "hawkishness" of December 2016 when compared to the same of December 2013.

Despite "reflation" and the bond market selloff of the past few months, the 5s10s is still around just 50 bps. Economists have no idea what that means, but after just about ten years now, it should be a perfectly clear indication of expectations for continuing, unanswered monetary instability. Just ask the Chinese. Again.


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

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