That's Your Globally Synchronized Downturn, the Fourth

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Let’s say you are a Japanese bank. Given the pitiful domestic investment choices you have for the near-infinite amount of bank reserves the Bank of Japan will create, where do you put any of them to work? You can’t leave them on account in resident money markets because negative rates are punishing. Japanese government bonds (JGB) offer little to no help, “yielding” less than zero on most maturities, too.

This, by the way, is the whole point of NIRP – or negative interest rate policy – in the first place. Central banks want their cadre of local banks to engage in risky behavior.  In order to nudge (shove) them in that direction, monetary policies are designed to punish risk-aversion. Banks that hold the safest and most liquid assets, such as JGB’s or bank reserves on account, they will have to pay for the privilege.

Since NIRP has been instituted, most do. Globally, banks are refusing to abide by the negative reinforcement. The central banks want them to lend so that economic recovery might actually happen and they simply refuse.

That doesn’t mean the banking system doesn’t get creative in how it has refused. While purposeful in avoiding lending domestically in yen markets, Japanese banks in particular have been busy over the last decade working out ways to work around low and negative rates while still playing it safe and liquid.

If you are a Japanese bank, a 10-year JGB yielding -20 bps is especially unattractive given the equivalent 10-year US Treasury sports an interest rate around +180 bps. But how does one get there from Tokyo without incurring too much unwanted additional risk?

Fortunately for you, there is an enormous, hidden funding market that exists for banks all over the world. No one really knows how big it is because on only the rarest of occasions does anyone in any official capacity bother to look. Among the few who do venture into these global offshore shadows, the numbers they find are simply staggering.

One BIS study from September 2017 put it at around THIRTEEN to FOURTEEN TRILLION, and that’s just what was lurking in the footnotes of bank filings.

Because that funding market is denominated in US dollars, though, you are in luck if your endgame is that UST. Or any other sovereign; US dollar funding is useful if not necessary to obtain those, too.

To go from Tokyo to New York, you’ve got to take yen and make it UST’s. The most direct route is the repo market. Adjusting for haircuts, which on UST’s these will be minimal, as a Japanese bank in good standing you simply buy the security from any dealer and then straight away “sell” it back to them. It is, after all, a repurchase agreement. As a collateralized loan, that’s all it really takes.

But it’s going to cost you a bit, and given how the rest of funding markets are behaving it may be the costliest route. One reason why is the dealers themselves; a repo loan is accounted for as a repo loan, and even if it isn’t risky to any serious degree it requires balance sheet space which is the most precious monetary commodity in the post crisis era.

For a dealer to allocate that much space for a vanilla repo loan, it’s not very enticing given a range of alternatives.

An FX swap, on the other hand, they’d do that in a heartbeat. And functionally, it all works out nearly the same for you – but not for the dealer.

As a Japanese bank, you’ve got yen (you are drowning in yen reserves) and if you don’t like the effective costs of straight US$ repo you can get the US$ funding you need via a currency swap. Here, the only part that’s really different is that you’ve pledged the yen as one piece of the deal. The goal remains the same: to increase yield on safe instruments without incurring too much additional risk.

For the most part, in this foreign context that means currency risk. You’ve got yen to swap for dollars, and now there is the risk that the dollar moves adversely against the yen which could destroy all your carefully laid plans. But the FX swap takes care of that because it is set so that the value of the yen you swap for dollars today is the same as when the derivative expires in the future. No exchange risk.

Thus, you pledge yen today for dollars in order to buy that UST, and if you run a matched trade which sets up the maturity of the UST to coincide the expiration of the swap the whole thing just unwinds near automatically: the UST matures giving you the dollars to be swapped back into yen and closing the book on the whole thing.

Except now you’ve earned UST interest instead of JGB. This is the real yen carry trade.

But why do dealers want to do it this way rather than straight repo? Because in the FX method of funding there is practically no balance sheet cost to the dealer. Currency swaps and the whole zoo of related derivative contracts are booked as, well, derivative contracts.

A repo is loan; therefore, it goes on the balance sheet at par value. FX as a derivative gets booked instead by its market value, which, in almost every form of swap or forward, starts out at zero. It requires no balance sheet space initially, and over time the only way that changes is if the contract value of the swap materially shifts.

This, by the way, is completely legal and in accordance with every single international and domestic accounting convention. Banks are doing nothing wrong as far as those go, they are merely taking advantage of how money has evolved but accounting like official conception hasn’t.

As you might imagine, it can lead to all sorts of, shall we say, misunderstanding.

To begin with, the world at large has no real idea how you’ve managed to acquire that UST. What shows up on your own balance sheet is “too many” US$ assets and no apparent US$ liabilities which must’ve funded them. You’ve still got that initial yen liability penciled in but on the other side across from it there’s now a dollar-denominated asset.

There might only be a footnote buried deep in your annual report that even suggests the possibility of some exotic FX somewhere in between. Both you and your dollar dealer (who doesn’t need to be an American bank, either) very much like that aspect of this offshore gray area, too.

When that BIS study was first published way back in late 2017, it received very little attention even though it said “this debt is, in effect, missing.” I wrote immediately in response:

“But it’s not missing and it never was. It’s out there and it is working and doing things, playing some large, perhaps majority role in the global economic condition. These trillions can only be categorized as ‘missing’ because the world’s monetary ‘experts’ never bothered to look for them. That doesn’t make them missing, it shows monetary authorities as utterly incompetent and clueless. Content with their own indoctrinated ignorance, they have conducted their policies with only a third or less of the monetary picture in hand. It isn’t hard to fathom why things have turned out as they have in too often globally synchronized fashion.”

At the time, it was globally synchronized growth which everyone said was going to continue. Today, it is globally synchronized downturn. The entirety of the mainstream is unable to fathom how the one became the other. Turning most often to the dubious idea of trade “sentiment” simply because the more basic trend of protectionism in the form a few billion in US tariffs on Chinese goods can’t account for how the entire global economy has been pushed into danger.

The most important passage in the whole of the BIS paper was actually this:

“Moreover, for highly active dealer banks, the balance sheet shows only the net result of a possibly huge number of deals for dealer banks very active in the market.”

In other words, the FX way of doing things allows dealer banks to cram as many transactions, therefore swapped hypothetical “dollars”, as possible into the smallest of balance sheet allocations. That’s not just hidden leverage; in funding terms, it means not being able to identify sources of trouble and imbalance as they begin to unfold. And it spreads any balance sheet problems far and wide among “a possibly huge number of deals for dealer banks.”

There are no small problems.

Like, say, if the FX market becomes fickle, balance sheet capacity begins to look a little too precious because of volatility and whatnot (maybe China around October 2017 declaring globally synchronized growth a complete lie), and that increasingly over time pushes you and all your Japanese cousins from FX swaps toward the repo market for funding.

With a prospective onrush of eager to maybe desperate borrowers in repo (think unmatched swap transactions, which is the real-world way things work), and dealers not overly thrilled to fund you in that market during the best of times, they might just sit on their hands and let repo and other money spreads rise and rise.

You would think, therefore, it would be exceedingly important to understand all those “possibly huge number of deals” if you are, say, Jay Powell sitting around the FOMC table at the end of October 2019 still trying to figure out that whole repo thing from September.

The minutes of that last FOMC meeting, released this week, announced how policymakers were trying to do just that. And also not having very much luck:

“The manager pro tem noted that diminished willingness of some dealers to intermediate across money markets ahead of the year-end could result in upward pressure on short-term money market rates.”

Diminished willingness of some dealers to intermediate across money markets. Let me repeat that again for the nth time: diminished willingness of some dealers to intermediate across money markets.

What happened in September just like all these repeating eurodollar problems I’ve been writing about the last decade, they all come back to this one thing. It has almost nothing to do with the level of US$ bank reserves. That’s a point many people have a hard time coming to grips with; after all, we are told repeatedly how the Fed prints money, creates liquidity, and those are bank reserves.

Therefore, it seems, quantitative tightening which was the central bank reducing the amount of bank reserves quite naturally fits as a plausible sounding explanation for an obvious liquidity breakdown.

But, no, bank reserves don’t really matter; balance sheet space does and much further up the chain of those funding liabilities. Even the FOMC minutes spell out the first part (while remaining frustratingly silent on the second):

“Many participants remarked, however, that even in an environment with ample reserves, a standing facility could serve as a useful backstop to support control of the federal funds rate in the event of outsized shocks to the system.”

Translation: even though the FOMC is increasing the level of bank reserves via its not-QE small-scale asset purchase, authorities realize they still need some other “useful backstop” because “ample” or any level of bank reserves guarantees them absolutely nothing.  

Chairman Powell said pretty much that very thing at his press conference the end of October:

“In addition to that, in addition to that, we’re looking at, there are, it’s a big, complicated marketplace, and there was the, one of the surprises, as I mentioned, was that banks that had told us that their lowest comfortable level of reserves was here. They were well above that, and yet they didn’t deploy that liquidity when there seemed to be great opportunities to do that. That didn’t happen.”

A big complicated marketplace where dealers well above their lowest comfortable level of reserves didn’t deploy liquidity when spreads showed huge opportunities for them to do so. A diminished willingness to intermediate across money markets. As I so often ask, where are the dealers?

Rather than working non-stop to figure that out, these offshore balance sheet frictions, our best and brightest central bankers have come up with a little thicker smoke and slightly more polished mirrors. Overnight repo operations will continue as will not-QE and the raising of irrelevant bank reserves.

Unlike the many other times in the recent past when funding problems arose, such as the last time 2014-16, the usually compliant financial media isn’t so sure this time about the FOMC’s lackluster, obviously haphazard response. Couple that with the fact authorities still have no answers for anything that’s going on, and you end up with a Bloomberg article (Bloomberg!) that says this:

“Taken together, it’s readily apparent that Fed officials are throwing the kitchen sink at the short-term funding markets and hoping they’ll settle down. The results so far have been fine but hardly perfect. Powell told lawmakers that ‘we’re prepared to continue to learn and adjust, but it’s a process and it’s one that doesn’t have implications for the economy or general public.’ That may be, but it certainly has ramifications for confidence in the central bank to carry out it’s [SIC] core responsibility of controlling short-term interest rates.”

Those ramifications are pretty easy to sketch out in broad terms, too. The world tells you that the Fed has got US$ liquidity covered if not over-covered. All your training and education says the same thing. And yet, for the fourth time in the last twelve years, you can see with your own eyes and hear with your own ears how that just isn’t true and at times, like the dress rehearsal in September repo, in a big way.

That makes the financial world the entire world over a much riskier place to try and operate. The key reason why such a shift impacts a lot more than domestic US considerations? Let’s go back to that 2017 BIS study one more time:

“The dollar reigns supreme in FX swaps and forwards. Its share is no less than 90%, and 96% among dealers. Both exceed its share in denominating global trade (about half) or in holdings of official FX reserves (two thirds). In fact, the dollar is the main currency in swaps/forwards against every currency.”

That’s the whole point of a global reserve currency. It is, as a I wrote not long ago, a middle currencywhich efficiently translates all sorts of economic and financial demands from across an entire spectrum of often unrelated national systems into easy and effective economic and financial results. Take away the smooth functioning of that middle currency, and economy or finance become less smooth to the point of harmful instability.

Everything suffers to varying degrees. Globally synchronized growth predictably swings to globally synchronized downturn.

The key distinction is what that middle currency really is. There are no eurodollars, printed Federal Reserve notes flying across all the world’s oceans settling hundreds of trillions in tiny short run transactions. It’s all about balance sheet capacities. The ability of dealers to carry out the vital roles of the world’s reserve currency regime. Credit-based eurodollars.

You want to swap yen for UST’s? Credit-based “dollars.” You want to swap yen for Singapore bonds? Credit-based “dollars.” A company in Brazil wants to ship China raw material? Credit-based “dollars.” A firm in Europe is trying to build capacity in Thailand? Credit-based “dollars.”

Powell is right; it is a big, complicated marketplace but the FOMC doesn’t factor even a fraction of it. He is more than half a century behind in understanding the thing, and intellectually hamstrung by geographic borders that matter for him but not for anyone operating here. To the Federal Reserve, all that money remains missing – and it shows.

Why are dealers sitting on their hands? What makes them so shy often at the worst times? What’s the harm?

Balance sheet capacity is the only way to begin answering all those questions. And officials aren’t even serious about asking them. Bank reserves and not-QE’s, overnight and term repo operations that don’t even touch repo. That’s your globally synchronized downturn, the fourth one. 

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

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