Central Bankers Can't Solve What They Don't Understand
Since reopening from its Golden Week National Holiday, Chinese markets have plunged. The benchmark Shanghai SSE stock index is down nearly 12% (through yesterday) in just nine trading sessions. It is an obvious liquidation event. The loser in the trade war?
That’s not really the game, however. The real one that is being played in the dark is one at which no one will win. There can’t be a winner. The end result, as we’ve seen time and again, is only variability amongst all the losers. It’s not at all the same to declare we might’ve lost the least, as will be the temptation here, certainly not after these last eleven years.
For the second time in as many years, the Chinese government is issuing Eurobonds. Last October, China sold about $2 billion in debt securities denominated in dollars in offshore markets. Two issues were floated, one with a five-year maturity and a second coming due in ten years. The yields came in at a very small spread above similar maturities of US Treasury debt.
It had been the first dollar bond sale by the country since 2004. The Chinese government funds itself typically in local RMB terms. It doesn’t require dollars for financing any of its vast activities. The dollar bonds have historically nothing to do with the fiscal situation.
Instead, the purpose is to provide the market with a benchmark risk-free. Not just any market, though, this same offshore dollar market nobody ever talks about. There’s growing difficulties in them which the past two years has caught at least Communist attention.
Officials are attempting to alleviate some of the problems the country faces by being “short” US dollars. Not the government specifically, rather the corporate sector largely financial firms. There is no global trade without someone having access to these offshore markets.
Hoping to get those markets thinking about China under more favorable terms, starting with such a low risk-free, the federal Eurobonds might reduce the costs for any firms following under them. Perhaps you might not know it with all the melodramatic focus on “trade wars”, but it’s becoming exceedingly difficult to fund in dollars again.
Therefore, the Chinese government may not need them for its own purposes but the country as a whole cannot get along without eurodollars obtainable on reasonable terms.
It began around last September. While Economists were declaring victory, demanding pieties over “globally synchronized growth”, something had changed. China’s currency had been rising for months but hit a landmine early in that month. The flow of foreign reserves into official hands, one measure for the direction of dollar activity in China’s corporate sector, had been at least slightly positive after the nightmarish experience from 2014 through 2016.
What a nightmare it was, though Janet Yellen casually dismissed it as little more than "transitory" factors. In June 2014, China held just less than $4 trillion in foreign exchange reserves. These were spread out among a variety of different currencies and then converted into several assets of various classes. By and large, however, the single biggest category of them was, and remains, US Treasury securities.
By January 2017, there was left just a shade under $3 trillion. The nation’s undefeatable stockpile had shed almost a quarter of its total, nearly $1 trillion – and the system was defeated anyway. CNY, the currency exchange rate against the dollar, had plummeted despite what every Economist on the planet had explained was surefire insurance against just this sort of thing.
This is a staggering consequence in its own right, more so in light of what forced this trillion-dollar drawdown. To this day, no one seems able to offer a legitimate answer for it. We hear about how China has all the cards in the trade war, holding so many of US Treasury assets. We anger them enough and they sell them all, we are warned, blowing up the US system.
Well, they sold hundreds of billions during a two-year period and it was the Chinese who ultimately bore the brunt of the process. The whole world thinks of international money upside down.
The one thing Economists got right in 2017 was globally synchronized growth, at least the idea of it. No matter what had happened in 2015 and 2016, or 2008 and 2009 for that matter, a worldwide recovery would make everyone forget about all the systemic shortcomings piled up by decades of determined official ignorance. In other words, if they got this last one right then all might be forgiven. Little wonder there has been so much emotion tied up in those expectations.
That’s what’s so special about growth. No matter how severe the imbalance, no matter the grave concerns associated with them, they pale in comparison to robust, sustainable opportunity. The naysayers (like me) fade into historical noise when confronted with the holy grail of social progress and undeniable (meaning rate of change) increases in everyone’s living standards. Opportunity is everything.
Even the debt burden of World War II was erased by the advance of a globalizing world economy. It was gold exchange of Bretton Woods that may have started it, but it was something very different that took it to its ultimate peak eleven years ago.
Unfortunately for us, politicians have no idea what that is because central bankers and Economists operate as if it is still 1956. Thus, when presented with the 2017 case for globally synchronized growth it wasn’t immediately met with the required skepticism. It was a runaway literary success, but in actual economy not so much.
Globally synchronized growth is now practically dead and buried. The narrative is no more, meaning that it was never really anything tangible. Economists aren’t yet ready to throw in the towel on everything, they’ve just begun to contemplate the consequences. So, the global economy won’t accelerate toward paradise, they now say, but at least it’ll be pretty good.
Except that’s not how these things go. There are processes at the top just as there are those at the bottom. The Titanic doesn’t turn on a dime. Operating under, as noted a few weeks ago, the modern doctrine of “benign neglect” central bankers in particular can never perceive the slow turn.
Right out in front of the parade of obliviousness is Jay Powell. The man is convinced the US economy is taking off right before our very eyes. As the rest of the world smells smoke and wonders where the fire might be and how far it may have already spread, Powell whiffs the sweet smell of success, appreciating the fine notes of all its smokiness. He is, you see, very, very confused.
As stocks in Shanghai plunged yesterday, the Federal Reserve’s New York branch detected a domestic raise in temperature. The effective federal funds rate (EFF), an almost meaningless historical anachronism that still somehow functions as the centerpiece for monetary policy, raised itself once again by another single basis point. This has nothing to do with policy rate hikes, instead it is the placement of the effective rate inside the policy frame of reference (corridor).
It’s precisely the point that “something” is being registered by federal funds, this low-volume pocket change of a market, that should get people’s attention. Whatever is going on out there deep in the offshore shadows must be substantial else it wouldn’t be detected here by this otherwise irrelevancy. Federal funds is the smoke detector set way far at the other end of the building just beginning to beep, except you can’t really hear it for all the other blaring alarms scattered about everywhere else.
The effective rate is, as of yesterday, 2.19% and now just 1 bps below IOER. Setting aside what that actually means as a technical matter, it tells us unequivocally they really don’t know what they are doing. On the most basic of basic levels, federal funds is their one job. Federal Reserve officials don’t even understand federal funds, but they know the economy is about to overheat?
In response to EFF having moved too far up in the accepted policy range all year to that point, the central bankers in June performed a “technical adjustment.” The FOMC would set IOER 5 bps below the top of the federal funds policy range rather than equal to it so as to pressure the effective rate and thereby act as a ceiling for EFF. In August, the Committee would declare victory of sorts in the skirmish:
“Over the days following the June FOMC meeting, the effective federal funds rate [EFF] moved up relative to the IOER rate, reportedly reflecting some special factors in the federal funds market.”
They did not specify what those “special factors” had been other than to say, “These developments proved temporary.” Except, with EFF now only 1 bps below IOER, they can’t have been truly temporary.
It may be minutiae but it’s not unimportant; it may be an irrelevant market in the grand scheme of things, but they can’t even get this right. If they can’t do the little things right, it raises the chances they don’t have anything right.
One very big thing policymakers have missed is May 29. It keeps getting bigger by the month, which is to say it always was what it was but our limited statistical capacities to measure the scale of the market earthquake striking that day means we can’t easily grasp its significance straight away. It was a collateral spasm of simply astounding proportions, estimates of those proportions which now almost five months later continue to grow.
Two months ago, when the Treasury Department first released its TIC figures for the month of June 2018, the month that immediately followed May 29, it showed a single anomaly. In the category of US bank liabilities to foreign entities, “other” financial firms outside the United States had apparently supplied $183 billion in “other” short-term securities. Though we can only guess the form of them as well as their origination, that was an enormous supply very much in line with the significance of the market tremor of May 29.
Only, the following month the estimate was revised higher. In September, the Treasury Department figured that in June the cross-border collateral offer was $240 billion rather than $183 billion. If the first estimate was incredible, what’s the proper description for a quarter-trillion?
Except the latest numbers, released this week, now show that it wasn’t $240 billion but instead $318 billion, or almost 75% bigger than originally assumed. It was hard to describe the size of the first one; this updated estimate is simply beyond words. Something huge happened mere months ago.
Like EFF, in early August the FOMC would refuse legitimacy. In attempting to argue why the US Treasury yield curve is so flat when it really shouldn’t be if the Committee is right about, well, anything, they actually stated “the strong worldwide demand for safe assets” might be rendering the prospects for an inverted yield curve invalid.
I wrote back in August only somewhat incredulously in response, I’m perhaps more accustomed to the level of arrogance and denial than most, that what they were attempting to claim was all sorts of unreasonable.
“The yield curve is flat and therefore the long end is mispriced because it is correctly pricing these things. You would never associate ‘strong worldwide demand for safe assets’ with a true economic boom – unless you have to…The FOMC is perfectly free, of course, to speculate wildly and irrationally in order to dismiss the ramifications in terms of a(nother) global ‘dollar’ disruption and the myriad deflationary signals multiplying and broadening, but that’s a luxury the world just doesn’t have.”
Which, of course, brings us right back to China. The Chinese are “losing” reserve assets all over again for reasons no one will be able to specify, leading to continued money supply restrictions inside of China and therefore rising economic risks (and much worse than mere risk) that the media will tell you is the result of China being the unfortunate loser in the trade wars.
And the US can be seen as the victor – until the whole of the global economy turns around as it already has three times before, each one having followed the same general monetary pattern.
It’s not that Economists and policymakers (redundant) don’t know the rules of the game, they are attempting to play an entirely different one on the same playing surface as everyone else. That’s why they can’t get the small things right, and not just EFF, nor any of the big things, and not just collateral and May 29.
What China’s second Eurobond offering proposes is actually two things, neither of which imply anything the least bit good. As stated above, Chinese officials are working in all channels to alleviate eurodollar funding pressures which are rising; we know that from 2018’s dollar bond as well as the renewed downfall of reserves and further internal liquidity adjustments (that aren’t working) signaling expectations for more of the same eurodollar conditions ahead.
Second, it shows that despite years of making noises about replacing the dollar if not with yuan then some international currency standard, they still aren’t even close to a successor. Former PBOC Governor Zhou Xiaochuan first made mention of China’s dissatisfaction with the dollar (really eurodollar, as Zhou correctly identified it as a “credit-based” reserve currency system) all the way back in March 2009. In 2011, CNY settlement of cross-border trade and financing activities was being promoted broadly and loudly.
That was seven years ago. If there was any realistic alternative to the eurodollar even in a regional setting (which, in this globalized economy, would be largely pointless anyway) it would’ve been used especially during 2014, 2015, and 2016. And then 2017, if there was something close to being serviceable, roll it out so as to avoid what has happened in 2018, merely repeating the eurodollar squeezes of the past.
I bring all this up for one purpose. It’s nothing to do with eliciting sympathy for anyone involved. Rather, it’s to remind everyone the intractability of the problem, one that though they may not have known it (but should have, echoing the words of Governor Zhou) China is equally guilty for having signed up for this. Their modern economic miracle was built solely on the foundations of international money. If that doesn’t go right, guess what, no miracle.
We are all losers together because we are stuck with this. Jay Powell is merely championing his predecessors all the way back to Paul Volcker. If policymakers don’t have the slightest idea what’s going on in the monetary world, they can’t even begin to solve the problem because how would they even know there is one? Surprise, surprise, they don’t.
Most people don’t, either, except to perceive vaguely what’s missing. It always comes down to opportunity. Chairman Powell talks about the strong economy even globally still and most people may not argue with his position but they know regardless something isn’t there. There’s no money in monetary policy and we are getting further along into another period when there’s just no money.