A Continuation of Everything That's Been Wrong for Eleven Years

Let’s start with the premise of maturity transformation. This simple concept forms the basis for the orthodox understanding of the relationships between a central bank, the banking system, and then ultimately the economy. Banks invest in loans and securities that are longer in maturity than the funding they acquire to be able to do those things. The difference is the presumed shape of the yield curve, where you pay less at the short end for funding than you receive from longer-dated assets.

Bank profits are supposed to be made by that difference. And if banks are making profits on the things that banks do, the economy is thought likely to be much better off for it.

Too much of a good thing can be bad, so says Economics. Enter the central bank. Using its presumed power to set money rates at the short end, the institution is supposed to alter the profit condition such that it can affect bank credit therefore the economy. And the theory says it does so in predictable fashion.

If the central bank believed that credit growth was sharpening too many of these “bad” imbalances, it might intervene in the profitability of maturity transformation. Make funding costs a little (or a lot) more expensive, and therefore curtail the excesses of the financial system. The economy is supposed to slow down as a result, but that’s a good thing, too.

Ultimately what anyone wants is not all the growth we can manage in a short period of time, rather the necessary aim is sustained maximum growth over a very long stretch. Monetary control of this type, according to the concept, is a very important control rod so as to ensure the second, healthy version of economic expansion.

That’s what everyone believes, anyway.

The Federal Reserve is right now undertaking just such a policy adjustment. In the view of its econometric models, the US economy is facing “balanced” risks; which simply means that it is as likely to take off as fall down. Those risks are, in the official interpretations of modeled economic simulations, in the process of becoming more unbalanced – in favor of the upside. Thus, rate hikes.

This would be a very welcome change. It’s not just that risks have been unbalanced the wrong way for so long, it’s that it hasn’t been limited to just forecast risk. The economy has been pushed into what are really mini-cycles, alternating limited upswings with periodic and significant downturns. The net result of these harmful oscillations has been a recovery that just hasn’t happened. Not yet, anyway.

If the Fed is right, then now it might. Halleluiah.

Why, then, are bank stocks suggesting a very different scenario? The disparity is much greater in the share prices of global banks. You could make the argument that the US economy is in much better shape, reviving the cleanest dirty shirt argument with a little additional economic bleach. That would suggest the Fed’s policy and the projections as the basis behind it applied only to the domestic system.

Global banks don’t work that way, though. They are everywhere all at once, inside the US and out. That’s what was behind the whole concept of Systemically Important Financial Institutions, or sifi’s. Deutsche Bank isn’t a German bank, for example, it is a globally important one that just happens to have kept its headquarters in Germany.

There are 39 sifi’s according to the Financial Stability Board. The FSB used to be the Financial Stability Forum (FSF), but in April 2009 it was rebranded for obvious reasons. The FSF, started in 1999, was meant to be a focused worldwide effort where experts from all over could get together and share information and interpretations. Their aim was to prevent a worldwide financial anomaly – like the panic that had just finished the month before the name change.

The problem with getting a bunch of central bank officials and Economists together to narrow in on financial stability is that central bank officials and Economists don’t really know much about the financial system. They think they do, but 2008. And 2011. 2014. 2018?

Mario Draghi, the current head of the ECB, was Chairman of the group from 2006 to 2011 during the world’s biggest runs of financial instability since the Great Depression.  In April 2008, Draghi, as Chairman, wrote:

“Some of the weaknesses that have come to light were known or suspected within the community of financial authorities before the turmoil began. Much work was underway at international levels that – if already implemented – might have tempered the scale of the problems experienced. However, international processes for agreeing and implementing regulatory and supervisory responses have in some cases been too slow given the pace of innovation in financial markets.”

Anyone buy that? For one, he and the FSF were largely silent on “some of the weaknesses” until after Bear Stearns had failed. Not once was the word eurodollar mentioned, the most cutting channel for “innovation” in monetary and financial history to date. Does anyone actually ponder why these global banks matter on a global scale, after all?

Thus, in the aftermath of the last crisis the FSF became the FSB and it decided that these firms should be identified and scrutinized. The list of sifi’s would include more than mere depository institutions, there could be insurers and even non-bank firms among the catalog. The nature of global banking and money is not strictly cash deposits; it isn’t even much about deposits, or cash for that matter.

Having identified this group, we are in 2018 now supposed to ignore them. We have to; otherwise globally synchronized growth starts to look more like a pipe dream than a solid, rational expectation. The Financial Times sounded the discrepancy more than two weeks ago:

“Investors on Tuesday sent the Nasdaq to a record close on the eve of a meeting at which the Fed is expected to lift rates for a seventh time since the end of 2015. But strategists note that beneath the bright economic data and rising benchmarks, strains have begun to emerge among a group of banks and insurers deemed to be critical to the health of the global financial system.”

Sixteen of the thirty-nine sifi’s had seen their stocks drop by more than 20% from recent peaks. Too many of those peaks were already molehills to begin with. The list has grown in the few weeks since. The article notes dryly, “At some point…central bankers might have to respond to bearish signals from almost half the global Sifis, rather than continuing to tighten monetary policy.” But why? Things are in danger of becoming too good.  That’s why they are “tightening” monetary policy in the first place.

This didn’t happen the last time around, either. In the middle 2000’s, though there weren’t yet designated sifi’s the systemically important names all saw their share prices rise often substantially. Alan Greenspan embarked on a final mission to normalize monetary policy after the dot-com experience, starting with “rate hikes” in June 2004. They would be completed by Ben Bernanke in June 2006.

During those two years, again, shares of even today’s most reviled names soared. Deutsche Bank, a bank that can’t stay out of the news, saw its stock trading ~$73 per share on the NYSE when Greenspan started. By the time Bernanke finished up two years later it was ~$105. It would peak in May 2007 at more than $150.

It fit the narrative. The Fed was “raising rates” because it wanted to be sure that a good thing didn’t become too much (the narrative, not effective reality). That good thing wasn’t the US economy’s recovery from a mild recession in 2001, it was a global tidal wave of transformation a lot of which nobody really understood. Mario Draghi claimed they had identified “some of the weaknesses” but experience denies his revisionism.

DB’s stock this week registered a new record low. It fell below $10.50 a share, a 93% collapse from the 2007 peak. That’s down 50% just since January.

People are quick to dismiss it as one extreme case. It’s easy to contrast DB against someone else like JP Morgan. JPM’s stock was as late as March at a record high; not a close record, either, rather JPM like a lot of US stocks had been on a tear last year. Since the February 2016 low, it had more than doubled in price.

A mild 11% price correction from that record isn’t, by itself, anything to get worked up about. Not with Morgan’s “fortress balance sheet.” But we can’t help but notice that of those sifi’s in bear market territory all of them are foreign.

Again, to most people that just goes to show how the US economy is supposedly performing (booming!) as opposed to the rest of the world (which already starts to shatter the idea of synchronized in globally synchronized growth).

The most important piece that Mario Draghi and FSF missed was not just the eurodollar, per se, rather it was what the eurodollar truly represented. It seemed like it was an easy “plug and play” sort of set up, where the proliferation of financial products (to use Greenspan’s monetary dodge) seemed to just naturally add on to the existing framework. It didn’t matter even geographical distinctions, it was simply assumed that there was great stability to the pliability of the arrangement (no matter what Draghi tried later to cover up) which then created the conditions for rapid global growth.

In truth, it turned out to be somewhat backward than all that. In other words, it all fit so easily together because it was growing rapidly. The pace of expansion, qualitatively as well as quantitively, meant that no one really had time to stop and think about it all. Parabolic growth was like an addiction. Take away the growth, and the cracks become more than visible; they stand out as insurmountable chasms.

Starting August 9, 2007, onward, geography mattered. For one, if a systemically important bank in Germany had been growing its US$ money dealing business in offshore markets to the point of untold trillions, what recourse would that firm have to the Bundesbank? Or anyone else, for that matter? JP Morgan could go to the Discount Window (which was changed to Primary Credit in 2003) directly, or whatever other novel program the Fed may dream up after that one didn’t work, but only DB’s US subsidiary would be available for domestic, onshore US$ “rescue” which would be much more complicated than it sounds.

The Federal Reserve, of course, came to this realization late, starting only in December 2007 with the introduction and implementation of US$ swaps – with foreign central banks, not foreign sifi’s. It didn’t address the geographic fragmentation, rather it added several more layers of bureaucratic inputs that on their face are antagonistic to a dynamic situation like any bank might face under severe strain.

Nothing the Fed did was effective anyway, most of all the dollar swaps. But that remains an important distinction regardless. US banks have to deal with the Fed’s monetary incompetence in their own back yard while foreign banks don’t really even have that. In the eurodollar’s world, the 2008 panic showed, proven beyond doubt by what happened in 2011, there is a liquidity risk premium to overseas operations in offshore money well above domestic activities performed even in the same offshore markets.

Enter liquidity risk.

What made the financial innovations offered by the sifi’s so apparently seamless was balance sheet capacity growth. It was the energizing factor behind everything, the faculties to do strange and often wonderful things because those strange and wonderful things would then become the basis for the next set of strange and wonderful things. It was self-funding in a way, piling up one innovation on top of the other as if an inverted pyramid could be so stable.

But the way in which it all happened was predictable and rigid. Money markets obeyed a certain hierarchy with only minor, temporary exception. For one example, the repo rate fell below federal funds or LIBOR. The latter two were unsecured interbank lending rates, whereas repo is collateralized. If the repo rate strayed too far out of alignment, money dealing banks would arbitrage the difference such that any wandering was never more than brief.

Many officials, Draghi included, appear to have assumed that this arbitrage just happens because it has to happen. The eurodollar system, however, doesn’t hold to self-evident truths like it might under a physical gold standard; the whole thing is relativism on steroids. Arbitrage isn’t a thing all its own, it is a widespread agreement of how things should work enforced by widespread ability to make it work in just that way.

What happens when not everyone knows what to make of relative changes? If behavior is unpredictable, there can be no arbitrage; there is no “should.” Thus, the repo rate might stray in relationship to the unsecured rates and nothing is done about it.

It might sound ridiculous, but that’s just what has happened over the last ten years. Formerly rigid and dependable hierarchy has intermittently vanished. Not totally disappeared, there are times when it comes back. Rather, arbitrage seems to go away whenever we encounter these times when global US$ conditions act in very evident tightness.

These gyrations line up very closely with the mini-cycles in the US economy that outside the United States have proven to be much more severe.  An American downturn might turn out to be a year or more of recession-like weakness whereas for other places it’s outright catastrophe. In the last two of these, far more negative intensity to their overseas effects.

The GC UST repo rate has been rising again. In relation to federal funds or the Federal Reserve’s RRP, it is noticeably high just as it was in 2015-16, 2011-12, and 2010. In fact, if you plot the repo rate’s spread to RRP what you find is a pattern that doesn’t just correspond to something like DXY’s movements, it fits them like a glove. DXY is the most widely followed US$ index.

Let’s be clear about what we are talking about. Whenever the repo rate goes high, it is denying the hierarchy or arbitrage that was once baseline practice. From that we can infer only lack of balance sheet capacity, which inaction further breaks down the level of predictability necessary for hierarchy and arbitrage. Banks grow cautious and pull back capacity, the GC rate tends to violate hierarchy, making banks even more nervous and leaving it as is, it goes further in disobedience, banks become even more nervous, etc.

Where does that nervousness register first and most emphatically? It hits the weakest places, such as any eurodollar banks that might not be so solid or so solidly onshore. Liquidity risk and its fragmentation premium.

That brings us back to the Fed. In addition to its “rate hikes”, the US central bank is also normalizing its balance sheet because it for now is sticking to its optimistic forecasts. Whereas QE increased the level of assets and therefore bank reserves (as nothing more than a remainder) this so-called QT reverses the process. There’s your tightening, many have said.

OK, fine. You want to believe the Fed’s tightening too much and that’s to blame for what’s going on now. What about the last time, or the time before that? Or the big one before those?

In other words, what we are seeing today isn’t something new like the monetary policy is.  It is, in fact, a perfect continuation of everything that’s been wrong for going on eleven years. Repo among all the eurodollar things is a relatively straightforward factor. Its signal is unambiguous in a way that leaves little doubt as to what’s really wrong. Balance sheet capacity, not bank reserves.

From the US domestic perspective, eurodollar decay happens starts from the outside and works inward; the weakest get hit first. It is weakest at the fringes of the overseas offshore connections, and those most exposed to those connections.

Brazil’s central bank already this month has been spending tens of billions of its forex “reserves” to get hold of the real; to no avail. India’s central bank was rumored to be in the market this week as the rupee dives to record lows. Even Big Mama has been jumping over the past few days:

“’The kind of dollar selling from that bank was so aggressive that we knew instantly that it must be from the Big Mama,’ said a Shanghai-based senior currency trader at an Asian bank, referring to the Chinese central bank’s nickname among local traders.”

Via one of its state-owned banks, the PBOC wasn’t really “selling dollars” so much as supplying them to its catch of an increasingly desperate offshore eurodollar market. As CNY plummets again reminiscent of its experience in 2015, are we really supposed to believe, contrary also to the sifi’s, it’s all because things are becoming so good? 

No wonder the yield curve keeps flattening. Nothing changes. Not even the capacity for the ridiculous or the steadfast belief in the absurd. Starting with stability.