Global Monetary Authorities Still Aren't Asking the Right Questions

Global Monetary Authorities Still Aren't Asking the Right Questions
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Beginning in June 2004, during the 108th Congress, the Senate began to hear testimony which in its words was “regarding the consideration of regulatory relief proposals.”  The Senate Committee on Banking, Housing, and Urban Affairs would continue to investigate these various applications well into the 109th Congress.  It was nearly two years before the whole legislature would produce what became known as the Financial Services Regulatory Relief Act (FSRRA) of 2006. 

From just the name of the Senate Committee fronting the bill you can probably guess that its contents were a miscellany of various crusades.  Section 801 related to the statutory inconsistencies according to the Fair Debt Collection Practices Act with regard to the widespread practice of local DA’s (more than 500) contracting with private entities in the administration of pretrial diversionary programs for those alleged to have bounced checks.  Section 704 sought to clarify “that the authority to prohibit golden parachute payments includes nonbank holding companies as well as depository institution holding companies.”  Section 201 authorized the Federal Reserve to start paying interest on reserve balances, but not before October 1, 2011.
The reason for wanting such authority over IORR and IOER was the belated recognition of deep changes to the monetary system that had been building for decades, ever since the first money market fund incorporated a sweep feature.  These reserve avoidance mechanisms were of some concern to the Fed, which alleged that they might absorb resources and therefore diminish systemic monetary efficiency. In its 93rd Annual Report (for 2006) encompassing the new authority provided by FSRRA, the central bank claimed:

“Moreover, if the Board were to determine to pay explicit interest on contractual clearing balances, once authorized to do so, the action could provide a stable enough supply of voluntary balances to allow the Federal Reserve to effectively implement monetary policy using existing procedures without the need for required reserves.”

That theory was put to the test long before the original legal authorization allowed. It was moved up to October 1, 2008, under the Emergency Economic Stabilization Act of 2008. Barely a month later, however, the Fed was forced to change the methodology of calculating the interest rate charge. In its first iteration, both IORR as well as IOER were set at the lowest effective federal funds target during any maintenance period minus 35 bps.  Beginning November 5, 2008, the rate would instead remove that 35 bps discount so as to equalize to the target federal funds rate.  As the Federal Reserve explained in its accompanying press release, the different calculation was brought about to, “help foster trading in the funds market at rates closer to the FOMC's target federal funds rate.”

On the day that change was made the effective federal funds rate was 0.23%, where the target rate for federal funds was still 1.00%.  To this day, I still find very little mainstream appreciation for this condition as well as its opposite, that of offshore dollars (really “dollars”).  Whereas federal funds were insanely low, LIBOR rates were insanely high; 1-month LIBOR was on the fifth of November 1.95625%, while 3-month LIBOR was 2.50625%.  The 3-month T-bill equivalent yield was more like federal funds, just 0.39%, leaving the TED spread, an indication of risk, particularly liquidity risk, at an enormous but still appropriate (given what was happening) 211 bps.

The thing is, even pulling IOER up to the then federal funds target of 1.00% had no effect.  None.  In mid-December 2008, the day before the FOMC finally pulled the trigger for ZIRP, the effective federal funds rate was even lower, just 18 bps, and had been lower still, 11 bps, the week before.  This interbank world had been governed, up to August 9, 2007, by hierarchy that was conspicuously absent.  “Something” big was missing.

A separate press release issued by the Fed on December 2, 2008, inadvertently confirmed this fact.  It stated the reauthorization for another three months of the Primary Dealer Credit Facility, the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility, and the Term Securities Lending Facility.  The new expiration date would be pushed back to April 30, 2009, so as to harmonize with the same maturity for the Fed’s Commercial Paper Funding Facility, the Money Market Investor Funding Facility, and the reciprocal swap lines with the expanded list of fourteen counterparty central banks.  Clearly, “something” big was missing.

You can easily claim that during crisis something big always has been and will always be missing, but in this case it was more than any others.  Of all the alphabet soup of acronyms they put together, only one, just one, was aimed at where the problem actually was.  And it was perfectly obvious and visible, for the spread between LIBOR and federal funds had not in decades been more than a few bps at reasonable time premiums.  That federal funds would fall below target and stay there while LIBOR would explode and stay there should have been the only information the Federal Reserve needed in guiding it as to how to respond (particularly since this very disparity had previously developed back in the summer of 2007, and the unusual spread of LIBOR to federal funds never went away).

It was clearly a huge foreign demand for dollars but in offshore capacity rather than onshore.  Domestic institutions were instead hoarding dollars, as witnessed by federal funds 0.11% in December 2008 when the target rate was still 1.00%.  Not only is that perfect commentary on the location of the problem, it also shows very clearly that funding markets had no faith in the Fed to fix it.  This despite those dollar swap lines that by that time were in use of up to $600 billion tendered out to foreign central banks for redistribution in their local jurisdictions. 

Is it any wonder, then, that there was another liquidation that occurred in early 2009?  The market for federal funds as well as LIBOR practically demanded one.  Though LIBOR rates came down with the institution of ZIRP, they did not anywhere near what would have signaled normal or the slightest hint of monetary policy success.  By January 14, 2009, 3-month LIBOR was still a little more than 108 bps and would start from there to rise again. 

That point was offered in another dimension of dollar markets, where dollars are truly “dollars.”  Despite all the liquidity programs and the apparent hugeness and capacity of the swap lines, interest rate swap spreads had in late October turned negative at the 30-year maturity and remained that way.  The Fed was acting in considerable fashion across a whole range of efforts, but nothing it did had much effect (a recurring theme that, importantly, persists long after the events of this period). 

It needs to be pointed out at this juncture that the dollar exchange value during all this was exploding higher, too.  In late July 2008, the index of the trade-weighted exchange value of the dollar had been 95.028 but was 103.949 the second week of October in full panic. By the time the swap spread 30s had turned negative in late October it was nearly 108. And when the spread between federal funds effective and the federal funds target was at its maximum, it neared 111.  Despite ZIRP and dollar swaps and all the other letters thrown into what was intended as a “currency elasticity” soup, the dollar would only pause briefly before rising yet again in early 2009, peaking by mid-March 2009 at greater than 114.

The rising dollar had nothing to do with a “strong dollar” policy whatever might have been pledged by the Treasury Department Bush or Obama, nor did it have anything to do with the US economic outlook as it might relate to foreign economic outlooks.  And it certainly wasn’t related to monetary policy and interest rate differentials which were at that time highly unfavorable, and getting more so, to this theory on currency exchange.  It had everything instead to do with federal funds vs. LIBOR, and what was further indicated by the negative swap spread. Foreign agents were having to pay up an enormous and increasing premium to receive what should have been regular dollar funding.   

Ben Bernanke would later claim it took a great deal of courage for him to act as he did under such pressure, some years later going so far as to write a book about his bravery (how brave of him).  If he had been truly courageous he would not have told Congress in March 2007 that subprime was contained but instead that he was very concerned the Fed didn’t know what it was doing because there was a great deal about the global monetary system he and it didn’t understand (a possibility Bernanke himself raised several years before under the ploy of some “global savings glut”).  He might have then clarified that he further feared the consequences of what an onshore/offshore rupture might mean in the short run as well as long term for the care of the dollar, and therefore global economy, to which he was charged by law and by accepted practice.

Instead, as FSRRA, he and the Fed would remain committed to a policy of exclusively domestic bank reserves to great and continuing disaster.  On a philosophical level, the idea is very simple.  From the perspective of orthodox economics there is no reason for recession let alone bank panics.  And since recessions are often liquidation events, the solution to them is to prevent liquidation through liquidity. 

And yet, through all that concerted effort the system liquidated anyway. That was bad enough on its own, and we can argue whether or not it was a necessary condition (it was), but what first needs to be appreciated is that the system is today, just about a decade past the first major rupture, still liquidating.  It has not ended.

Again, from the view of bank reserves this should be completely impossible.  Yet, it has been constant throughout, leading to a great deal of exasperation in private from Federal Reserve officials (I urge everyone to read through the 2011 FOMC transcripts like those from 2008).  The most glaring example has been of late China, a country whose economic “miracle” was predicated on this offshore dollar but who in 2016 and 2017 has been forced by its absence to de-dollarize at an alarming and hugely destabilizing rate.  They are not, however, the only example.

A great deal politically has been made of Mexico, including the prospects for not just a border wall but also how that country might be made to pay for it.  It has become common in the media to cite this as the reason for Mexico’s burgeoning currency crisis.  Like so much that was and remains of commentary surrounding the events of 2008, it is a false narrative.  The peso doesn’t fall on Trump.

The peso, in fact, started dropping at the same time nearly every other currency around the world did.  In late July 2014, there were just less than 13 pesos for every dollar.  By February 11, 2016, at the end of that bout of global liquidations, there were then more than 19.  All that occurred long before Donald Trump was taken seriously in the mainstream as a candidate. 

It was a familiar occurrence for the peso, however, as from August 2008 through March 2009, Mexico’s currency collapsed then, too (from 10 to just about 16).  So it should be no surprise, but sadly is, that conditions this week have brought about rumors that Banxico is considering an official appeal to the Federal Reserve for dollar swap lines. In late February, Mexico’s central bank announced already an intent for non-deliverable currency hedges against the dollar, payable in pesos, with some $1 billion such “hedges” being offered starting next week.

Instead of acknowledging all the clear parallels and circumstances that scream “dollar”, we instead are forced to consider only “analysis” like that which got us into this mess in the first place.  From Bloomberg on Wednesday:

“Circumstances surrounding a possible request [swap lines] are made even stranger by the fact that it is this very Trump talk -- renegotiate Nafta, build a border wall, deport more undocumented immigrants -- that has driven much of the selloff in the peso over the past year. Mexican officials, in other words, would be turning for help to the same country that is causing much of its troubles.”

This is politics not economics, and nothing like monetary economics.  Again, the peso has no visible issue with Trump, but it does have everything to do with “dollar” even ten years later. How many more examples do we need of the dollar shortage before its continuing destructive impacts force someone with standing to do something about it?  Mexico can’t readily source “dollars.”  The rest of the world can’t readily source “dollars.” We know without a doubt that it should not be central bankers left anymore to deal with this consistent problem, for they have had this last decade to figure it all out and have responded instead with their heads tucked firmly in the warm sand of econometric models that quite intentionally disregard offshore currency as even a possibility.   

Dollar swaps from the Fed to Mexico would be a disaster, not just fail in preventing further disaster.  Economists have yet been made to reconcile why it was that $600 billion or so dollar swaps to the whole world in late 2008 failed to prevent another devastating global liquidation – the very one that plunged the global economy to its worst point and likely broke it for good (as stated also very clearly by the lack of recovery in almost every country). It is on this limited point that monetary officials have finally admitted defeat (though they blame retirement and drug addicts for it).

Brazil as a parallel case illustrates this great defect with interventionist ideas, particularly in systems that interventionists don’t understand.  That nation’s “solution” to its “dollar” problem arising first in the summer of 2013 was very much like what Mexico has already chosen to do.  As I wrote in mid-August 2015, just days after everyone was shocked and confused by what China had done with yuan:

“The real’s appreciation eventually did halt, but instead of providing the utopian monetarism Banco sought has turned into an ongoing nightmare in the opposite direction.  In August 2013, there was more cupom auctions to be had only this time not ‘reverse swaps’ but of the straight variety, as much as they may be in Brazil.  Rather than try to influence “dollars” away from Brazil to halt appreciation, the central bank was getting desperate to induce Brazilian banks to attain them.  And so the bank began a series of auctions, historically large, which had the practical effect of making Brazilian banks even more ‘short’ the ‘dollar.’”

It is what I have called the nightmare scenario, which has proven a dreadfully accurate bit of overemphasis.  The problem with any country short of “dollars”, which is every country, is not the “dollars” so much as the short.  In Brazil, the central bank made it artificially more profitable to do the most dangerous thing local Brazilian banks could do, and all because the central bank doesn’t get the danger. If you believe that the Fed’s massive balance sheet swelled with bank reserves created by QE’s is actual money for the global system, then you will believe that contemporary dollar problems for any country including Brazil, Mexico, or China are those of temporary disruption in distribution rather than chronic destruction of capacity. 

Brazil has paid dearly for this view, but they are just the most extreme example of this nightmare that no one has yet been able to escape.  It is not a mistake that should have been made, as going back to late 2008 should have clarified this entire matter.  The difference fed funds to LIBOR, or swap spreads, or even GC repo to federal funds, all have spoken as to something big missing – capacity.  Liquidations in this way were not temporary reductions in supply, rather they were permanent reductions in capability for maintaining “dollars” especially outside the United States. 

Because the Federal Reserve does not recognize that there is a parallel global “dollar” system that in most ways supersedes the domestic one, it has been largely a bystander (apart from any indirect and limited QE or ZIRP on expectations) even during periods where it didn’t appear to be. This global “dollar” runs on banks, the Fed believes instead the dollar runs on it. We have been subjected to a decade of intense experimentation clearly and forever establishing the Fed is only full of it.

Just last week, the 4-week T-bill equivalent yield was 39 bps, about 11 bps less than what is supposed to be a money market floor as determined by the RRP (reverse repo program).  The GC repo rate, too, in UST was less than 50 bps. These speak to chronic issues with monetary capacity, and those are just in the domestic sense. Hierarchy in money markets is gone because capacity is gone. 

LIBOR rates are and have been for several years well above the so-called money market ceiling set by none other than the IOER (no longer aiding in establishing a floor).  In theory, banks should be arbitraging the difference, lending instead in those eurodollar markets rather than parking cash idle at the Fed.  But LIBOR in many ways pertains to a method of money flow that is no longer viable; like federal funds there just isn’t anyone there anymore.  The “dollar” system stripped of so much capability has been pushed into other places (FX) where it struggles in new ways.  As I wrote almost one year ago:

“The negative yen basis swap acts like leverage where even yields on the interim ‘investment’ are negative.  Any speculator or bank with spare ‘dollars’ could lend them in a yen basis swap meaning an exchange into yen.  Because you end up with yen you are forced into some really bad investment choices such as slightly negative 5-year government bonds, but that is just part of the cost of keeping risk on your yen side low.  Instead, the real money is made in the basis swap itself since it now trades so highly negative.  The very fact of that basis swap spread means a huge premium on spare dollars; which is another way of saying there is a ‘dollar’ shortage.”

It is a situation that just should not arise for very long, let alone persist and proliferate through all the major currency FX pairs.  There should be no doubt anymore that something big is and has been missing.  It is bigger than the Fed and all the world’s central banks combined. 

In the grand scheme of all things money, what has been taking place is the private liquidation of money dealing capacity to which various central banks are forced to respond incompletely (they can never do any else).  They fail largely because they refuse anything but their own ideology which is blind to this decades old offshore reality. In many ways and at key moments, because of this philosophical limitation they actually make it worse (see China; ticking clock). 

Why was there a third (the first to Bear, the second after Lehman) liquidation in early 2009 despite those dollar swaps? Or was there a third liquidation at that time because of those dollar swaps?  The global economy has failed to recover because among other things those in position of authority have never asked the right questions. There is no evidence to suggest they ever will.  The events of 2008 should have been long before now relegated to a topic exclusive to historians and academics.  Instead, it remains relevant today as a means to put to rest that which should have been realized long before now.  

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

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