Powell Isn't Spiking Trump's Re-Election, He Wouldn't Know How

Powell Isn't Spiking Trump's Re-Election, He Wouldn't Know How
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It doesn’t matter that the yield curve has been warning about this for well over a year. For most people, they were left unaware of any dangers. Aside from the occasional high level mentions here or there, for all 2018 there was the unemployment rate and nothing else as far as the economy was concerned. Federal Reserve Chairman Jay Powell said so numerous times.

This year has gone very differently. The 2s10s, the difference between the 10-year US Treasury yield and the 2-year US Treasury yield, has finally turned negative meaning inversion. Widely considered a recession signal, all of a sudden everyone’s a bond watcher.

Among the numerous other factors that have been displaying this disappointment is the increased intrusion of politics into monetary policy. The Fed has never really been independent, at least not in that way. Independence for the central bank really means accountability, or lack thereof.

It has been President Trump who is now attempting to bridge that gap – though for all the wrong reasons. The growing uncertainty in the economy, according to the President, is Jay Powell’s fault. Having characterized the situation several times as the greatest economic boom in the country’s history, it was apparently driven off course by the eight rate hikes since his election. I guess that mean Janet Yellen needs to be called in, too.

If that 200 bps increase in the federal funds range spread out over two years doesn’t quite strike you as much of a difference, certainly not a drastic shock which would spoil even a modest boom let alone the best one, then maybe it was quantitative tightening which added to the benchmark rate changes has now produced alarm instead of celebration.

Earlier this month, the President again complained about what Powell had done. In a pair of tweets published on August 8, he wrote:

“As your President, one would think that I would be thrilled with our very strong dollar. I am not! The Fed’s high interest rate level, in comparison to other countries, is keeping the dollar high, making it more difficult for our great manufacturers like Caterpillar, Boeing, John Deere, our car companies, & others, to compete on a level playing field. With substantial Fed Cuts (there is no inflation) and no quantitative tightening, the dollar will make it possible for our companies to win against any competition.”

It's no accident the dollar is central to his case. Unlike the last time we went through this exercise four years ago, it has become more accepted how a rising dollar equals nothing good. It used to be the cleanest dirty shirt argument; the US economy is relatively strong compared with currency counterparts, and that “strong” dollar was a good sign of “decoupling.”

No longer; or, the myth isn’t nearly as widespread. Having noticed the correlation but not yet the causation, the mainstream has moved on to another explanation. The most obvious difference between this time (2018-19) and the last time (2015-16) are those rate hikes (and QT). Therefore, if not dirty shirts then mustn’t it be interest rate differentials?

The Fed was hiking into a booming US economy while other central banks around the world weren’t. Worse, as this new theory goes, the rest of the world weakened meaning markets began to see rate cuts in the foreign future. Against the backdrop of presumed continued US strength, the dollar rises as “hot money” chases a clear differential in the dollar’s favor.

And now pity poor John Deere, Boeing, and Caterpillar while at the same time recoiling at their plight and what it could mean for all Americans, a consideration reflected back at the public now from the 2s10s.

But this one’s even more tortured than the last stab at an explanation. The good thing of investors betting on US strength, as the rest of the world falls apart, and buying up dollars because of it…is supposedly a bad thing which is already well advanced on its way toward wrecking that very US strength? Something’s missing here.

The only solid thinking among these scattered pieces is that the President is alarmed, he wants to set up Jay Powell for the fall, and the dollar is in the middle of all this – somehow.

How else might one attempt to explain all the facts? The dollar is up, the boom, assuming it ever was one, is in danger, and the bond market must be involved some way.

There is and has been a role for Jay Powell just as there was for Janet Yellen, Ben Bernanke, and all the others in this wretched process. And it has everything to do with rate hikes, or rate cuts for that matter.

The earliest known official reference to the eurodollar market that I’ve yet been able to locate comes from November 1960. It was around this same time William Clarke of the London Times coined the very term. Before then, others had used the label Continental dollar to refer to increasingly robust trading, in dollars, all across Europe.

The term eurodollar was a natural fit.

Writing for the Federal Reserve Bank of New York’sEconomic Policy Review circular, authors Alan Holmes and Fred Klopstock, both of FRBNY, recount their findings from a survey they had conducted in Europe among European banks in June 1960. They write how the eurodollar market was by 1958 already well-established though very little was known about it (a condition which would remain in place until the BIS’ first published study in 1964).

There were various reasons given for why this market had sprung up out of nowhere. To begin with, the Communists in the Eastern bloc had grown wary of holding dollar correspondent balances at US banks, but still needing those dollars chose to deposit them with British and French banks instead. The sterling crisis of 1957 pushed more of global reserve business toward the dollar. But most of all, governments tended to look the other way when banks were dealing with foreign customers in foreign currencies.

Eurodollars were not treated as part of the domestic money supply – anywhere - for any local banks holding these liabilities. It had carved out a truly separate space for itself, leaving the term “offshore” universally applicable. The eurodollar was offshore from everywhere.

Though this was, and remains, the case, the early eurodollar market was also given something of a stamp of approval. Many European central banks, if not all of them, were highly active in it. Foreign countries primarily held US dollars as their chief reserve, and the fixed exchange system of the time required their central banks to act when necessary. The eurodollar market provided these central banks with an easy, clean, and flexible place to either source or dispose of required dollar balances.

The biggest reason for its early success, however, was its breathtaking flexibility; it was essentially an open book. Banks were free to innovate and expand the boundaries of what was possible in every monetary and financial sense. As Holmes and Klopstock pointed out, “While, as in all markets, the amount that can be readily transacted at quoted rates may vary from time to time, it is normally possible for a prime name to place or receive deposits in blocks of $1 million or substantially more in a few minutes’ time.”

By 1960, it had already become an innovative departure from more standard (and known) procedure, pioneering practices that even today seem strange and wondrously complicated to most people.

“The emergence at that time of a fully integrated and active foreign exchange market enabled banks to take in deposits denominated in foreign currencies, ‘swap’ them into dollars, and use the dollars for investment in the Continental dollar market.”

Consequently, two regularly separated practices were essentially merged in eurodollar banks. Even for merchant banks who were the early adopters and who had historically dominated the foreign exchange markets, they had always kept their foreign exchange desk separate from their money desk. In fact, before the mid-fifties there had never been a reason why they would be closely linked.

The eurodollar market, however, revolutionized the way bank habits were being viewed; a fact very much appreciated in 1960:

“In many European banks the manager of the bank’s money position is also the chief foreign exchange trader, a practice which is virtually unheard of in the United States and which indicates the close link in Europe between money and foreign exchange markets.”

The person in charge had to know the amount of dollars, really “dollars”, which might be available not just today but in forward steps, too. And that knowledge dictated how the bank would transact in the foreign exchange markets. In the very earliest days of the system, the quantity of dollars was linked directly to the forex activities of everyone participating in it – including central banks.

Though foreign exchange values were fixed back then, it wasn’t a price mechanism which drove bank positions in that area. Once Bretton Woods finally broke down, and currency exchange values freely floated, it really didn’t make any difference. By then, eurodollar banks were already masters of money and forex, and had found several new innovations (more swaps, like crude early basis swaps) which allowed them to simply incorporate floating exchanges into their money-ed practices.

Where Jay Powell comes into all this is in the traditions of the Federal Reserve especially after Volcker. It was decided long ago that none of this eurodollar stuff would matter, officials at the time couldn’t understand much of it anyway (missing money), and that eurodollar supply was only partially applicable to US money supply (an uncompleted part of M3, discontinued in 2006 for that reason).

Authorities didn’t care what banks were doing out there in the offshore netherworlds. Control would be centralized in a single lever, utilizing to full effect the supposed Volcker Effect. The Fed would influence bank behavior, all bank behavior in all markets, by moving around the federal funds rate (interest rate targeting). Monetary policy wasn’t money it was a slogan: Don’t Fight the Fed.

Meanwhile, the offshore money world flourished and then some. The eurodollar system had met each of Robert Solomon’s three pillars for any reserve currency. By 1960, it already had the confidence of the dollar, had achieved the liquidity of banks offering huge blocks at a moment’s notice, and more than either of those was absolutely flexible for any demanded adjustments.

There were warning signs along the way of course, especially in 1998. Alan Greenspan himself worried all throughout the late nineties that being so disconnected from monetary proficiency might lead to big trouble.

But it all converged in the great contest of 2008. Does the Fed actually control money via the fed funds rate? The answer was an emphatic, NO.

Even dollar swaps with overseas central banks and TAF auction lists populated by “New York” banks with German and European names, these were no match for a truly global money system gone haywire. The Fed never really figured out nor admitted it was in way over its head.

But some things never change. The dollar’s exchange value remained linked to the money side of the eurodollar system. Only in March 2008, the very day Bear Stearns was announced, that meant the dollar would rise as the money in the offshore space was increasingly hard to come by. It was, in essence, a short squeeze reflected in the price.

If the Fed and Jay Powell in 2019 are to be finally and for once held accountable, let it be for something legitimate; not rate hikes and QT, at least not how these are commonly understood. The problem in one sense is rate hikes and QT but only in that what preceded them had accomplished absolutely nothing. The Fed had tried to solve a money issue with puppet shows, and then started to unwind the puppet shows at a time when the money issue returned to the forefront in the form of the “unexpectedly” rising dollar.

John Deere and Caterpillar need answers for a more expensive dollar in short supply, not relief from foreign investors eager to participate in their success. You don’t get an inverted yield curve from the “harm” being caused by the confluence of so many positives, you get an inverted yield curve because who buys the bonds is the same as who trades the money.

What Powell should answer for is how in 1960 there was more knowledge about the way things worked than there is in 2019. Near six decades difference and policymakers are distinctly more ignorant today. That’s actually much worse than if rate hikes were to blame for the yield curve warning.

In shifting to interest rate targeting all central banks made an ideological choice to let go of their technical monetary proficiencies. Around 1980, central bankers assumed (ASSUMED) they wouldn’t need them any longer. They would command to the banking system via the fed funds rate, and it would be left up to the banking system to figure out how to translate that policy communication into real monetary action.

The bond market’s role in all this is as feedback. As far back as 2017, the curves were all saying to Yellen, hey, you’re doing it wrong, you’ve got the wrong idea about the global system. She ignored the monetary warnings and then turned things over to Trump’s choice Jay Powell who wanted a boom on his resume no matter what.

The inverted 2s10s simply follow in line: money to dollar to it-is-getting-too-late for the economy.

This week, the FOMC noted cross currents, headwinds, or whatever they are calling them these days. The last rate cut was nothing more than a mid-cycle adjustment, the latest official minutes declare. Once the economy weathers these crossing heads Powell will get back to his boom. You’d think the President would happily play along, but he hasn’t the luxury.

Unlike the Fed Chairman, Trump has an election coming up. And yesterday IHS Markit, with its manufacturing PMI under 50 for the first time since 2009, said this about the whole economy service sector included:

“A number of private sector firms noted that less favorable demand conditions had held back staff recruitment during August. The rate of job creation eased to its weakest since February 2010.”

Nothing kills your election chances quite like out-of-work voters. They don’t even have to be laid off to turn on you; a little uncertainty as to whether they might end up laid off is more than enough. The tweeting suggests President Trump is quite well aware.

Powell isn’t spiking Trump’s election chances; he wouldn’t know how. If the President is defeated next year by a recession in between, it will be because he picked a guy to run the Fed who has as good an idea of what moves the dollar as he does. The problem facing 2020 is that they’re both still stuck in 1980 when they should have been wise to 1960.

Whoever might’ve said progress was linear has it all wrong.

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

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