It's Hard Not to See a Little Bit of 2007 In Recent Trends

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Bankrate recently conducted a landmark survey. It asked 2,740 Americans about their current financial situation. Intended as a comparison and therefore a measure of progress, there was only one standard or benchmark for making it. Are you better off today than you were in 2007? The Great “Recession.”

Of the nearly 3,000 surveyed, 2,315 were adults twelve years ago and therefore only their answers were included. The results should be astonishing but I doubt they will come as any surprise. The economy is booming, and yet everyone knows there’s something very different about this one.

Anyone can say it’s booming because a cursory review of the statistics seems to line up that way. As the Bankrate post itself notes, next month this expansion will have been the longest on record. There have been 104 straight months of job gains. The unemployment rate is at a 50-year low.

Despite all that, 25% of these Americans who were adults in 2007 today say their financial situation has not changed. A further 23% claim they are worse off now than a very, very long time ago. Bankrate’s senior economic analyst, Mark Hamrick, summarized it best:

“The echoes of the financial crisis and Great Recession remain very present in the financial lives of many Americans, despite the improvement in the broader economy. While some have managed to prosper in the decade since, there are still tens of millions who are struggling to even get back to where they were before the economy took a turn for the worse.”

Improvement in the broader economy; just how broad is “broader?” This is the very question which has perplexed Economists since 2007. There is an abundance of surveys relaying the same message; not just those conducted in 2012 or 2016, but in 2018 and 2019 each as the unemployment rate falls ever lower.

A study released last month conducted by the United Way’s ALICE project suggested 51 million households, HOUSEHOLDS, in the United States don’t earn enough to cover the basics of modern life. The term ALICE stands for: Asset Limited, Income Constrained, Employed.

Why is socialism so popular lately? Getting more so by each monthly release of the unemployment rate.

Recovery is a pretty well-defined term, which only makes it odd how ill-defined this one has been. Sure, the unemployment rate in the US hasn’t been this low since 1969, but, way on the other side of things, the participation rate makes for nearly the same comparison. To claim the economy is booming, you have to dismiss, somehow, the latter while the surveys pile up ever higher.

If there is so much uncertainty about these presumably good times, what’s about to happen as rate cuts are all but assured? In other words, we need to start thinking about the real risks of an economic downside that even the most optimistic group of optimists, central bankers, now take seriously; one which already begins in a significantly, and unusual, weakened state.

Economists also generally assume that an economy will keep expanding in perpetuity. This is another assumption that everyone is taught to take for granted; growth just happens. Be it population or productivity, the economy will always move forward – unless interrupted by some sort of substantial shock.

Set aside our concerns about the growth part for a moment, and let’s focus instead on the shock. In post-war business cycles these tended to be macroeconomic in nature; that is, typically businesses would over-supply, inventory would build up, and then all at once the supply chain would collapse on itself once defeated sellers start marking down the prices of their goods in a rush. Reduced retail orders led to lower production volumes triggering layoffs which only depressed retail sales further. And so on.

Much of what has become modern Economics has focused on the expectations part of the business cycle – to manage expectations so that the build up doesn’t ever get too far out of hand, and even if it does there is no reason for the supply chain to collapse into recession.

How? Monetary stimulus.

Faced with the prospects for a downturn, the central bank reduces interest rates spurring banks (maturity transformation) to increase debt. These “looser” financial conditions temper if not entirely supersede the downturn in consumer and business spending.

In 1988, Economists Brad DeLong and Larry Summers wrote:

“That the business cycle consists of repeated transient and potentially avoidable lapses from sustainable levels of output is a major piece of the Keynesian view: there is often room for improvement, and good policy aims to fill in troughs without shaving off peaks.”

But what if there are no peaks?

It’s the stuff of Jay Powell’s nightmare, what he and the other policymakers call R*. The Federal Reserve as well as the ECB are about to make the attempt anyway. Both central banks this week have more than hinted how next month will be the starting point for rate cuts in each. Having resisted for more than a year, finally the Economists admit of a building, serious economic downside spanning much if not most of the global economy.

In response, however, they rely merely on the same old playbook; with one huge exception. It used to be called the zero lower bound, but now it’s called the effective lower bound. However you label the thing, altitude is an issue already.

In Europe, their problem is compounded because the ECB has never been able to lift off from it. So much for their boom.

Either way, the manner for filling in the troughs is supposed to be straightforward rate cuts. Instead, both the Fed and ECB (along with the Bank of Japan after Japan inevitably leads the way lower) are going to be left with only “unconventional” policies; Europe immediately.  

That’s already an issue at least in the minds of policymakers; they really think, as noted a few weeks ago, that what really matters is how these policies are viewed by the public rather than what the policies actually do.

So, even if you believe in the mainstream position you begin with your recession-fighting toolkit handicapped. You can continue to think rate cuts are great and helpful, but even then the world’s central bankers are telling you they have a serious problem. And that’s before they even start.

What I am saying altogether is how everything is turning toward the downside. There was supposed to have been a boom, but even that’s debatable when it never should have been. Central bankers by now should be very good at filling in troughs, yet they’ve spent the last decade trying desperately to convince everyone they might have figured out how to get out of the last one which struck ten years ago if only given enough time. As such, faced with the prospect of the next trough, the last line of defense doesn’t even know how to begin a defense.

A much uglier reality appears in that light. In technical monetary operation, the central bank isn’t, actually, the last line of defense. It hasn’t been for at least twelve years, oddly enough dating back to around 2007. It seems the Great “Recession” has stuck in the minds of more than just American workers who see it as the historical dividing line.

Traditionally, the central bank was simply the lender-of-last-resort. This was Bagehot’s doing, their only job, the early doctrine which dominated monetary policy. In the latter half of the 20th century, central bankers stopped being bankers who thought about money and became Economists thinking only of peaks and troughs.

No one ever thought to ask, by becoming less the place for bankers and almost exclusively the place for Economists, have central bankers also stopped being the lender-of-last-resort for banks? We don’t really have to ask the question any longer, 2008 answered for us. And if you didn’t like the answer, 2011 settled the matter anyway.

No, central banks are not.

Instead, the repo market has taken on this burden. It tried in 2007 and 2008, but collateral impairment was simply overwhelming (MBS bonds of all kinds not just subprime that were shunned, leaving too little collateral for repo to effectively backstop global liquidity).  The Great “Recession” became great, in one big sense, because the repo market backstop itself required a backstop which didn’t exist.

Over the years since, the market has been somewhat rebuilt. It remains tepid, no longer so vibrant largely because of the same collateral pressures; a shortage of what counts as “pristine.” These are now mostly the top-level sovereigns, UST’s, bunds, and JGB’s, with agency MBS sprinkled in, too.

In the early days after 2008, the list included other government debt, things like Greek and Portuguese bonds. It did not go well.

The remaining forms have been supplemented, a sort of magic trick of expansion. The securities lending business has been around a very long time. The rise of repo in the seventies meant an opportunity for supplying collateral even to those who don’t have any. This offends every sense of capitalism, to begin with, for how can anyone participate in a securitized borrowing transaction when they don’t actually own the security backing it?

A broader category still, those who own some securities but not those most acceptable in repo. Before 2008, AIG made it a habit in securities lending to transform subprime “toxic waste” so that by the time it got out into the repo market it was “pristine.” This is called collateral transformation.

The financial system still does it. In fact, it may do much more of it now than ever before – not that anyone has any real idea. A chronic collateral shortage is, as anything, an opportunity for any outfit who can make collateral; or make less desirable stuff seem pristine. Nobody is transforming subprime mortgage securities these days, but there are always going to be other forms of junk which can be used at the basis of the transaction.

So long as collateral is in short supply, the need, and the incentive, to do this will be powerful enough to override disciplined boundaries. And the longer it goes on, the more confirmation bias that it’s all so very safe; this time we know what we are doing.

This was something that caught the attention of a very few policymakers what seems like a very long time ago. Former FRB Governor Jeremy Stein first raised the issue way back in 2013, what he called “reach for yield.” The reaching part, though, was not so much yield as funding. What he said was:

“Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does–say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.”

It's not so much an environment of low returns as it is an environment short of collateral during a time when low returns are prevalent (the interest rate fallacy). In fact, the two things go together; cause and effect.

What it amounts to, as Stein obliquely referenced, was the potential for poisoning the collateral pool all over again. The outside world only saw AIG posting pristine collateral when all the time in behind was its toxic waste as the foundational transaction. When “the world” suddenly realized the gamesmanship, there was a rush into actual, clean pristine collateral – which effectively ruined the only real lender-of-last-resort.

Following the break in 2008, much of the securities transformation business has focused on junk bonds (Eurobonds, too) and CLO’s. I wouldn’t say these are as bad as some subprime mortgage structures had been, but they aren’t enough different, either.

This isn’t to suggest there’s another subprime timebomb; only, the potential poisoning of the collateral pool, which extends into the derivatives business beyond repo, creates conditions ripe for another collateral bottleneck. What a shock that would be, something the bond market might rightly worry about with skyrocketing flight-to-safety (and primary dealers piling into UST’s at a historic pace).

The Great “Recession” was itself different than other post-war recessions in that way. It was caused by a monetary shock, one more like the Great Depression (though this time the panic was banks panicking). The Fed proved helpless in the face of two big imbalances running roughshod: first, the collateral issue which no central bank is equipped to handle; second, how the collateral bottleneck spanned the whole world (offshore).

The repo market is already overstressed. In the latest Z1 release (Financial Accounts of the United States), repo liabilities (in dollars) from the Rest of the World (ROW) had absolutely surged in Q4 2018 (when everything started to go wrong) and Q1 2019 (when it became clear everything was going to stay wrong); a near 30% increase in just those two quarters, amounting to $235 billion in just what we can see.

This last resort for funding, in the face of a dollar shortage in other forms of liabilities, could only have taken place with sufficiently distributed and accepted collateral.

Maybe we should be comforted by that fact; how during two pretty bad quarters the repo market was able to ride to the rescue (in lieu of the clueless Fed who stood helpless as the GC repo rate spiked to nearly 300 bps above RRP at the end of last year) to keep some bad conditions from becoming worse.

Then again, what would happen if the repo market hadn’t been there at all? Should collateral chains turn, no lender-of-last-resort. Even if it hasn’t yet, the very real idea that it could is a huge liquidity risk.

Some have said the bond market is being way, way too pessimistic. After all, look at stocks soaring, like, say, October 2007, to record highs. What would the downside be, though, if a global economy that rather than booming was still caught up in the last trough and when it started to weaken it did so with no central bank cover - and then was hit with a financial shock emanating from the very place that for years has been the entire world’s effective dollar lender-of-last-resort?

I’ve always thought the 2008 comparisons are overdone, but it’s hard not to see a little bit of 2007 in recent trends. It doesn’t really take all that much to admit there are serious downside risks right now. Even Jay Powell finally agrees, though he’s never going to admit it in public. He’ll just call the upcoming rate cuts boom insurance instead, and if that’s not enough he’ll suggest how low rates are stimulus at the same time those very low rates prove yet again there is none.  


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

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