Bond Yields Are Really Quite Easy to Understand

Bond Yields Are Really Quite Easy to Understand
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Marvin Goodfriend was nominated by President Trump to a seat on the Federal Reserve’s Board of Governors in November 2017. Within months, the Senate’s Banking Committee held hearings that were devastating to his nomination. And though that committee would formally approve and forward it to the full Senate, it did so on a razor-thin 13 to 12 vote which left the former professor and Federal Reserve Economist no margin to overcome what had been uncovered during those examinations.

Senator Elizabeth Warren, for example, hit Goodfriend with his own words time and again. “These wrong predictions are not outliers for you,” she said. Sherrod Brown, the panel’s top Dem, leveled another charge which came to symbolize, for many, the gist of those proceedings.

“We can't take a chance on someone with a decades-long record of prioritizing hypothetical inflation over real people losing their jobs.”

Goodfriend had criticized the Federal Reserve several times in the post-crisis era for its dependence on QE alone in attempting to rebuild the financial conditions necessary for full and complete recovery. He preferred even more radical steps like negative interest rates, even if that might require getting rid of paper currency to do it “right.”

Either way, Goodfriend was a hardened hawk, one of the generation of Economists and central bankers who had come up during the Great Inflation. This group always sees the specter of inflation around every corner. Though QE wasn’t exactly to his liking, he still thought it worked well enough.

He was already urging a fast series of rate hikes as early as 2012, claiming that once the unemployment rate got below 7% it would very quickly become very seventies-like without intervention. One of the many Senator Warren had in mind when making her blistering critique.

The unemployment rate would eventually fall well below 4% - and still no inflation. As part of completing its recent grand strategy review in 2020, the current Fed has stopped looking for it even as it now wishes the public to believe the economy will be hugely inflationary in the (near) future.

Common sense would otherwise plead for recognizing how something big must (still) be missing. And that’s perhaps the strangest part of Marvin Goodfriend’s last political experience (his nomination never was taken up for a full Senate vote and quietly expired without any further official comment). After all, as a staffer and eventually director of research at the central bank’s Richmond branch, the man had made his reputation by being thorough.

Of the very few who had long ago written about and accounted for the burgeoning eurodollar market, Marvin Goodfriend’s smattering of writings remain one of the scarce Federal Reserve sources on what was taking place in these otherwise shadow spaces.

To begin with, the big mystery. A good example is what Goodfriend wrote in the middle of 1981. On the subject of the eurodollar market specifically, he detailed its huge contradiction from the standpoint of the official perspective (all the while acknowledging how, as research officer for one of the Fed’s branches, he had to use private sources for any estimates).

“As of mid-1980 Morgan [Guaranty] estimated the gross size of the Eurocurrency market at $1,310 billion. The net size was put at $670 billion…M2 is the narrowest United States monetary aggregate that includes Eurodollar deposits. M2 includes overnight Eurodollar deposits held by United States nonbank residents at Caribbean branches of Federal Reserve member banks. As of June 1980, M2 measured $1,587 billion; its Eurodollar component was $2.9 billion.”

Not only that, total M3 (under contemporary definitions) was just $1.85 trillion.

This was a time when a few hundred billion was an impossibly enormous sum, and yet four decades ago only a few inquisitive souls were looking into a shadow money system that had already come to dominate global economic conditions (Great Inflation, after all) to the point that its gross size was two-thirds the entire broadest version of domestic money stock.

Even netted out, as central bankers like to do, it still summed to one-third the size of the entire perceived US-based supply.

These enormous figures had ballooned up from Morgan Guaranty’s guess of around $50 billion gross back when nearer the eurodollar’s start in the early sixties. Missing money, indeed.

Less than a decade later, each of the M’s had been surpassed by what nobody talked about. Turning again to Goodfriend, now writing in the early nineties, he again documented this incongruence using the same comparisons:

“As of March 1988, Morgan estimated the gross size of the Eurocurrency market at $4,561 billion; the net size was put at $2,587 billion… As of May 1991, M2 measured $3,396 billion; its Eurodollar component was $17.8 billion. This comparison shows clearly that Eurodollar deposits account for a relatively small portion of monetary assets held by U.S. residents.”

The gross eurodollar size was in 1988 a third greater than the entire M2 stock would be three years afterward, while its net size was closing in on two-thirds of it. And this was three decades ago.

Important to note the size as well as its rapid growth during the eighties, more important, perhaps, was that last little bit of Goodfriend’s writing; “Eurodollar deposits account for a relatively small portion of monetary assets held by U.S. residents.”

If American people and companies weren’t using these things, who the hell was?

For one, American banks; they are a big chunk of the amount which central banks like to net out from the gross. They justify this bit of subjective accounting because they’ve always assumed (incorrectly) American banks are strictly borrowers in this market rather than any source of supply creation within them.

Regardless, the rest of the world was obviously using these unofficial, bank-centered dollars by the trillions without any official recognition this was going on. And the trillions were only getting larger by the decade; by the year; by the month. Not for nothing, 1988 was the last year for which Morgan Guaranty estimated eurodollar size. Try as the bank might, it just couldn’t keep up and this was the one firm which had actually wanted to.

Around the same time Marvin Goodfriend was updating the Richmond Fed’s small circle of readers who read these sorts of circulars as to the eurodollar market’s condition, he had collaborated with that branch’s president, Al Broaddus, in explaining what they considered unrelated matters which pertained to the Fed and its ostensibly money-less monetary policies. In a preview of his 2010’s criticisms, neither Goodfriend nor Broaddus was particularly enthused by them.

Noting, importantly, that the Federal Reserve’s history was hugely suspect to that point, the central bank largely responsible for both the Great Depression as well as the Great Inflation forever staining its reputation and record, the pair turned to the all-too-few and brief times things had gone right.

“What's the problem? Why hasn't the Fed done a better job? I am going to argue today that one reason—and maybe the main reason—is that the Fed does not now have, and it never has had, a clear congressional mandate to stabilize the price level. Consequently, the Fed's success in stabilizing the price level in at least some periods of its history has been and continues to be a function largely of: 1. prevailing general economic conditions; 2. the strength of the Federal Reserve's leaders; 3. old-fashioned luck.”

Notice what’s missing from their list: monetary competence at any level. When the economy had gone right, they saw it as just the economy being left to go right on its own, or simply the random good luck that nothing monetary had stopped it (again, those few times outside the great monetary imbalances allowed to proliferate around the Great Depression and Great Inflation).

The only thing that the central bank may have contributed was some cult-of-personality sort of influence. Before the Great Inflation, that was a guy by the name of William McChesney Martin, under whom this gross of money had gone missing. In the years following Broaddus and Goodfriend’s early nineties criticisms, it would be a guy they’d end up calling “maestro.”

What’s weird, then, is how someone like Marvin Goodfriend wouldn’t have been able to better identify this “good luck.” While that may have meant something else before the advent of the eurodollar era in the late fifties, this “luck” would have applied differently in the eighties and thereafter.

What did they mean when they said “old-fashioned luck” anyway? To be specific about it, Economists James Stock and Mark Watson would write more than a decade later, in 2003, trying to do the same thing only explaining how the Great “Moderation” had come about and why it seemed to have become one of the few historical periods the Fed hadn’t managed to screw up.

Like the earlier duo, the later two also singled out the Fed’s leadership under Alan Greenspan (the so-called maestro) as well as this same “random good luck.”

“But because most of the reduction [in instability] seems to be due to good luck in the form of smaller economic disturbances, we are left with the unsettling conclusion that the quiescence of the past fifteen years could well be a hiatus before a return to more turbulent economic times.”

This would be very disquieting, if anyone knew about it. Precisely the point, the public has been told next to nothing about how central banks struggle mightily to explain the good times.

And while those times were good, in behind them all along this shadow money system getting larger and larger and larger. Not only quantitative expansion on that order, also qualitative expansion of money beyond every sense of traditional definitions – even by 1980’s standards. That’s one big reason why Morgan Guaranty had stopped trying to estimate the thing.

It proliferated in several dimensions making it all but impossible without undertaking serious time, effort, and, most of all, huge expense.

Which was one thing the Federal Reserve was never interested undertaking. The entire rationale for discontinuing M3 in 2006 was because it would’ve costed so much in the uncertain attempt to make M3 or some modern version of L into something hopefully approaching accurate and useful. Central bankers considered this a waste of time, effort, and, most of all, even the smallest expense.

Instead, a final nod to the real tenure of the maestro, the Federal Reserve decided to press onward betting the whole global economy on a combination of Fed cult leadership worship (rate hikes/cuts/eventually QE’s) plus that same “old-fashioned luck.” It ran out, like the eurodollars, not even two years later.

In reviewing this, a few things should stand out. First, how the Federal Reserve is not a dollar central bank, or a central bank in charge of the dollar monetary system. That’s what we are led to believe the institution does, take direct care of dollars broadly speaking (using bank reserves). Instead, the Fed is nothing more than a domestic bank authority whose actual authority ends at the US border.

In other words, officials don’t care a bit about dollars anywhere, really, but especially those outside America – even if nominally these are supposed to be American currency (virtual, but currency nonetheless). What the Federal Reserve does care about is the domestic banking system and therefore only how domestic dollars might affect that one single part of the overall global banking network.

That should have been the key lesson learned from Morgan’s numbers when broadcast by Goodfriend; the huge figures four decades ago had already shown this was a globalized monetary network, and, more obviously, something to take seriously.  

Narrowing down the focus like this, you really begin to appreciate at least how these people can think in terms of something like “good luck.”

Second, as a domestic bank authority which only cares about domestic bank conditions, it must therefore also be the central belief that all economic factors and aggregates, like inflation and unemployment, are determined solely by the condition of domestic banks. Ceteris paribus, as they say. All else, like the trillions in offshore shadow dollars and “dollars”, are treated as irrelevant and immaterial.

This brings us to Randall Quarles in October 2020. Yesterday, the Fed’s Vice Chairman for Supervision (meaning domestic bank supervision), Quarles, laid out the official view of the last thirteen years since that first global dollar shortage erupted in August 2007: we fixed the domestic banking system, therefore we get a huge pat on the back and everything should be fine going forward.

I’m paraphrasing, of course, but you can read his entire speech for yourself and see that’s a fair assessment of it. What that means for this year and next, in Quarles’ official view, is that since we avoided another Lehman or AIG back in March, everything is going to be awesome since the Fed obviously performed extremely well for its mandate.

They just can’t figure out inflation (expectations) and wonder why it looks like the post-COVID rebound might have already stalled out. Like Goodfriend in 2012, they still believe inflation and recovery, though.


“It appears that these short-term funding markets remain an unstable source of funding in times of considerable financial stress. The Fed and other financial agencies have accomplished a lot in requiring or encouraging market participants to rely less on unstable short-term funding, but it is worth asking whether there may be other steps needed to secure these very important sources of liquidity.”

So much for all those bank reserves. Banks fixed, but dollar markets not? This makes perfect sense when you realize how the Federal Reserve doesn’t concern itself with those markets especially those parts which operate outside of the US boundary. In fact, the vast majority of dollar markets operate outside of the US boundary, which makes it difficult inside the US boundary if what’s going on outside is continuously problematic (i.e.; shortage).

And so we are left – once again – to question this same proposition: is US economic health and potential just a function of functioning domestic banks? Or, does the entire global dollar system actually deliver, thus explain, the whole difference?

The Fed has given its answer repeatedly - Quarles simply the latest update to it - which has left our domestic bank authority with more than a decade of puzzles, mysteries, and moving the goalposts time and again. As it stands now, such run of “bad luck” is poised to continue, as is “wrong predictions are not the outliers” for them all.

In that sense, Goodfriend and Broaddus have been right all this time. Congress never gave the Fed mandate to think outside its limited banking box. However, this doesn’t let Fed officials like Greenspan off the hook; to the contrary, despite Goodfriend’s occasional documentation, Congress was never told or shown why it needed to. Nor the public.

That’s the dereliction; that’s their corruption. At least for Goodfriend, who passed away at the end of last year, he’s one of the few who suffered failure as his nomination went nowhere. The rest remain, somehow, in perfectly good standing. What’s worse, narrow official central bank opinion on both money and economic topics remains cast as if wide-ranging, incontrovertible, and thus the gold standard for the public to lean on.

As we head toward the close of this tumultuous 2020, yep, no Lehmans. But is that really the standard here, the actual goal? Had it been Lehman’s failure specifically that had made 2008 and its aftermath so awfully bad? Or had it been the shadow global dollar breakdown and shortage, of which Lehman like Bear Stearns or AIG had been merely specific symptoms?

If the latter, it appeals to a much wider and more comprehensive problem the vast majority of which continues to be outside the Fed’s jurisdiction as well as level of comprehension. As I’ve written constantly the past few years, bond yields really are quite easy to understand. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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