Someone Isn't Agreeing With the Fed's Groupthink

Someone Isn't Agreeing With the Fed's Groupthink
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In late July 2012, scandal broke. It had been hinted at and whispered about for years. But it wasn’t until four years after major crisis and five since he had pronounced it pre-contained that Ben Bernanke would finally speak about it. There were issues with LIBOR and the way in which the “fix” might have been, well, fixed.

In a blatantly transparent attempt to further discredit the thing and take some sting out of criticism for his own performance, the then-Federal Reserve Chairman went before an angry Congress (in truth, is there any other type?) demanding some answers. He was joined by then-Treasury Secretary Tim Geithner, who was during the worst of it Bernanke’s man at the Fed’s all-important NYC branch. FRBNY was supposedly running the place where banks all over the world connected to each other in, and out of, dollars.

Many in the media had taken to calling it the crime of the century. Wall Street was a favorite whipping boy and the shady dealings in LIBOR weren’t helping. Still, one sufficiently unawed Congressman, Republican Scott Garrett, caught the Federal Reserve Chairman in his intellectual no-man’s land.

“You [Bernanke] have been before this committee countless numbers of times since 2008 and if this is the crime of the century, as so many people are reporting today, never once did you ever once come and mention it as being a problem, never once did you come here and say this is what you’re going to do about it.”

This was two months before QE3 would be launched, and just seven months following a near rerun of 2008 in December 2011. Three days before Garrett’s mentioning the obvious, Mario Draghi was in Europe making his infamous promise to “do whatever it takes.”

The reason there was so much heat on central bankers was the pitiful state of pretty much everything at that moment. Draghi promised to do more, but both he and Bernanke had done a lot. None of it amounted to what the whole world was waiting for. LIBOR was a brief moment of hoped reprieve on the part of many central bank officials.  It wasn’t us, it was the banks!

It also provided some necessary clarity, though not intentional on Bernanke’s part. Deflecting blame, the Chairman testified that LIBOR wasn’t his animal. “It is constructed by a private organization in the UK, and so our direct ability to influence that is limited.”

That was true and in ways far more relevant than the interest rates and how they were constructed. LIBOR pertains to eurodollarmoney rates. These are ostensibly dollars on deposit in banks in London but more so all over the world outside the United States. Any offshore dollar pool is technically eurodollars.

The market for them over the last half century has evolved, to put it mildly. What started as literal dollars in literal deposits has become a trail of euphemisms where there are no dollars nor deposits. There are only bank liabilities. It is a pure credit-based system. In that respect, Bernanke was correct in 2012 to point out who was involved.

But he couldn’t go all the way. In other words, for every inch of him that might have wanted to outright blame England for this “crime of the century” he simply couldn’t. That would be going too far in a direction the Fed will not go. What does the Bank of England have to do with dollars?

There has always historically been a brisk trade between the US and UK, between the money centers of New York and London. But in 2012, as 2007, or 2018, London is but a small part of the global monetary network. LIBOR was set by the British Bankers Association, but it was about what funding resources (bank liabilities of all colors and shapes) were available anywhere else – just not inside the United States.

What could Bernanke say to that? Could he realistically admit to upset Congressmen in the middle of continued monetary and financial trouble that there was this massive offshore monetary system, most of which was conducted in dollars, where the Federal Reserve was essentially powerless to influence? His compromise was to suggest they had no sway over setting the rate. In truth, they had no sway on anything.

This gets right to the heart of the matter. Is the Federal Reserve responsible for only banks operating in the United States? Or, does the central bank owe responsibility to the currency? The dollar works well enough here domestically, but it’s the eurodollar that keeps pulling the world into repeated trouble.

Officially, they take the former mandate. It was easy to do so before August 9, 2007. Back then, global eurodollar markets operated seamlessly. The integrated capacities that led to a predictable hierarchy were obvious, if in the end illusory. With the Federal Reserve targeting the domestic federal funds dollar rate, that bank-imposed hierarchy provided the deception for their mandate.

Eurodollars in this view were some exotic investment choice, not an entire monetary and credit ecosystem operating only outside the borders of the United States. Officials looked the other way for decades simply because they thought they could.

In September 2007, the FOMC had come to realize some of the problems with their position. They debated all the standard stuff about what they might do to alleviate some of the sting from the “subprime” crisis that was far from being contained. It was instead spreading and worsening, originating in London oddly enough with LIBOR at the center of the crisis signal.

The way in which it did was really what mattered, and still does. It wasn’t NYC and domestic dollars. Kathleen Johnson, at the time a staff economist, perfectly described their dilemma:

“MS. JOHNSON. Of course, many of the dollar issues that we have spoken of— and that Bill [Dudley] talked about—are really being captured as a London phenomenon. But you might say that, from the point of view of the Bank of England or the U.K. economy, these dollar issues are somewhat separate from the domestic economy. There is some truth to that, but also the institutions are involved, the institutions have obligations, and the shocks to the institutions reverberate back into the domestic economy, it seems to me."

Again, is the eurodollar a British or US responsibility. Is it British banks, or US dollars?

The answer, of course, was and is both. And that is why eleven years on there have been no answers. Instead, we are left with only false dawns that reach 4% GDP occasionally before every time “unexpectedly” being hijacked by “transitory” “overseas turmoil.”

That was QE3 in 2012, the meager response to a second and lethal (for the last prospects on true recovery) global downturn. If you have to repeat QE once, let alone twice and three times (there was QE4 in December 2012), it doesn’t work. The Fed expanded its balance sheet, but it did not and could not expand the global eurodollar balance sheet. British, Swiss, Japanese, Hong Kong banks saw right through QE as a sideshow distraction.

How do we know what global banks were thinking and doing? And I mean actually doing, not what their Economists on every financial channel talk about. There is often a massive difference between what the official bank Economist says to the media and what that very bank does deep within its own balance sheet. The former are always like central bankers supremely optimistic and almost always the optimism is predicated on the theory behind something like QE.

In practice, the banks aren’t so easily fooled (and when they are, not for very long). It started very early on in the crisis, too. All the way back in March 2007, Bill Dudley, the head of FRBNY’s Open Market Desk, was at a loss to describe one important market’s increasingly desperate (offshore) monetary signal.

None of the FOMC members could grasp the disparity. Their models foresaw nothing worth getting upset about. The “banks” each said the same thing. Therefore, they couldn’t fathom why this market was causing so much trouble.

“MR. DUDLEY. Well, another explanation is that the economists who make the dealer forecasts are not the traders who execute the Eurodollar futures positions.”

The bank Economists were saying one thing while the bank itself was doing something very different. Eurodollar futures.

That meant, of course, not just US banks who were trading (redistributing) dollars, but all those global participants who began refraining from creating dollar-denominated liabilities (supply). The eurodollar futures signal was coming from this offshore dollar market populated by British banks as well as their counterparts everywhere else. These also included US banks, too, only their offshore subsidiaries operating in these money centers of London, Tokyo, and beyond.

We can relate. Today, the banks are uniformly positive in their Economist presentations. The Fed is right, rates are going up they all say. On TV or all over the internet, they are near perfect clones of Jay Powell. The Federal Reserve is doing what it does because all the models foresee only good things. 

And yet, “someone” isn’t agreeing with the groupthink. As I write this, the eurodollar futures curve is inverted and becoming more so. Going back to the events of May 29 (the massive deflationary pressure of a global collateral call), the curve between March/June 2020 and March/June 2021 had first compressed and then reversed.

A money or financial curve is supposed to be upward sloping. A normal curve, or the closest there may be to one, is actually rather flat and uninteresting. Its positive slope isn’t enormous, but it is obvious. That’s why inversions get our immediate attention; they are almost unnatural.

In terms of eurodollar futures, normal means the price of the next contract in the line is less than the one before it. The price is set by future expectations for where 3-month LIBOR will be at contract maturity. Therefore, under normal conditions we would expect 3-month LIBOR to be slightly more in June 2021 than in June 2020 (the price of the June 2021 should therefore be slightly lower indicating this expectation for higher future LIBOR). With the Fed’s “rate hikes” ongoing, that expectation perhaps should be a little stronger; that is, even more of an upward slope than normal.

Instead, starting June 13 the price of the June 2021 closed above the price of the June 2020. The gap has widened over the two and a half months since to about 4.5 bps at its most. Right now, however, the March and June 2022’s are now trading at a higher price than the June 2021’s, pushing the inversion out still another contract year.

On its surface, it appears that the futures market is saying LIBOR will be less in 2021 and 2022 than in 2020. Many people take it to mean like UST curve inversion that recession risks have risen for those specific years.

That’s not what the eurodollar futures curve is really telling us, though. Investors are becoming increasingly skeptical of Jay Powell and more so the reasons (rationalizations) behind his “rate hikes.” The inverted curve simply tells us that after some unknown amount of time there is a very good chance the Fed will be forced to reverse them.

In other words, like early 2007, the eurodollar futures market is disagreeing with the FOMC and the banks. Who are these investors? The banks. British, German, Japanese, American, etc.

What most often causes a central bank to so dramatically reverse course in this fashion is typically, like 2007, “unexpected” monetary tightening. Remember, eleven years ago the Fed was in much the same position. It had “raised rates” up to June 2006, and just as the eurodollar futures market predicted the central bank would in its cloud of self-imposed bewilderment reverse only starting in September 2007.

The problem isn’t eurodollar futures or LIBOR. If there was a crime of the century, it was in allowing this divide to go unsettled for so very long. It’s not like the issue hadn’t been raised before. Here’s former Bank of Italy Governor Guido Carli in 1979:

“The first [source of global instability] lies in the fact that the process of creation of international liquidity triggered by the U.S. balance-of-payments deficit is not only due to the increase in the amount of the dollar reserves in the hands of other central banks, but also to the presence of an international banking system that multiplies U.S. liquid liabilities outside the control of any monetary authority. The problem is old: it has been ten years since I first pointed to the need for some kind of regulation of the Euromarkets.”

That’s why Bernanke had to be careful about LIBOR in 2012. He wanted the scandal to be able to point at the banking system and by dirty implication blame it for much more than LIBOR. At the same time, however, he couldn’t go too far lest anyone follow the line of thinking into those uncomfortable questions about British banks vs. American dollars.

And so, he was left to face Congressman Garrett’s exposition which was essentially noticing the Federal Reserve’s massive contradiction: they kept silent for years about LIBOR because officially there is no eurodollar system. To suggest there was would be to admit the monetary system isn’t what everyone’s been told. The US central bank isn’t central.

Since the 2011 eurodollar crisis, the monetary system has tended more and more to carry out its repeated tightening at the outer reaches first – the emerging markets. It is no coincidence that the eurodollar futures curve is inverted now at the same time you may have read about increasingly dollar desperate EM countries.

This isn’t actually mechanically different than 2013-14. EM currencies during the last eurodollar episode collapsed, too, only the eurodollar curve didn’t invert. It did, however, flatten and by a whole lot starting with the longer maturities (back then, it was contracts like June 2017 and June 2018; again, the market wasn’t indicating in 2014 a recession for 2017 and 2018, rather that effective global eurodollar tightening would lead to a situation where LIBOR in 2018 would end up much, much lower than the optimistic mainstream models were predicting for recovery; the eurodollar futures market was right the whole time).

The only thing that is different, and what’s causing inversion this time around, is the Fed is “raising rates” at the very front. Again, the central bank isn’t central. They aren’t tightening nor the cause of recent eurodollar distress, merely announcing to the wider world with more clarity how they really don’t know what they are doing.

It is so far beyond which central bank should regulate what banks. Does the Bank of England take responsibility for US and Japanese banks operating in London? If they operate in dollars, is that the Fed’s turf? Doesn’t matter. What does is whose dollar it is. Once that matter is settled only then will it be possible to stop repeating the cycle.

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

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