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As I type, the eurodollar futures curve is exactly 200 bps inverted, solidly Holy Crap territory. US Treasuries aren’t far behind in terms of historical upset, while an unprecedented inversion in the market for Germany’s government debt gets more unprecedented by the day, week, and month.

In purely technical terms, all these together are betting heavily on lower interest rates all over the world in the not-too-distant future. As they’ve come to be this distorted and ugly, formerly aggressive central bankers who’ve been hiking rates as fast as they can are suddenly coming around to that possibility, too.

The question now, as it has been all along, is why.

And the most obvious answer is recession, meaning unemployment. Specifically with regard to what’s happening here in the US, the Federal Reserve has clearly and repeatedly emphasized halving its formerly-double mandate, nowadays fixated exclusively on the CPI (or PCE Deflator, if you like they prefer) rather than the previously pretending to balance between that and the unemployment rate.

Therefore, to get from aggressive policy action in response to consumer prices that have yet to convincingly display a sustained downward tendency into what these inverted curves strongly imply would be an equally aggressive policy action in the opposite direction (rate cuts) is not at all likely to be due to some minor nuisance. There’s obviously something big here.

If that means recession, which more and more appears probable (if not already), a modest rise in unemployment wouldn’t be enough to trigger full-on Fed reversal. From the sky-is-falling-inflation to the sky-is-falling-unemployment isn’t 2001’s moderate dot-com cycle.

How, then, to get there?

The other piece of yield curve inversion isn’t strictly economic. Decompose the yield into constituent parts as Irving Fisher did such a long time ago and you end up with growth and inflation expectations. When those are declining from short to long-term, it tells you something importantly fundamental about growth and inflation potential from the market perspective (which you’d be wise to heed closely).

An unhealthy dose of deflationary monetary conditions would aggressively lower growth and inflation while also triggering lower policy rates.

For so many years, the very notion of deflationary money continuously confounded, well, everyone starting with policymakers and cascading confusion from there. After all, bank reserves. So many bank reserves. For example, on August 9, 2011, the FOMC sat stunned, reacting to a massive and growing deflationary monetary break despite by then two completed QEs which had “printed” a gargantuan pile of reserves.

“MR. SACK. Can I add a comment? In terms of your question about reserves, as I noted in the briefing, we are seeing funding pressures emerge. We are seeing a lot more discussion about the potential need for liquidity facilities. I mentioned in my briefing that the FX swap lines could be used, but we’ve seen discussions of TAF-type facilities in market write-ups. So the liquidity pressures are pretty substantial. And I think it’s worth pointing out that this is all happening with $1.6 trillion of reserves in the system.”

At that time, it was considered one-to-one, that bank reserves were useful money therefore the creation, any amount, was an addition to “liquidity.” Yet, repeatedly, this has been shown to be false.

In response, the initial impression was, well, there just wasn’t enough. If even at $1.6 trillion there still came to be systemic illiquidity, then the system must need more. A little over a year after this discussion and an unnecessary major crisis in between, Mr. Sack’s Federal Reserve came back with QEs 3 and 4 (yes, there were four by December 2012).

And still these dollar shortages.

Any remaining honest observer could only conclude – at minimum - there cannot be a direct relationship between the system level of bank reserves (which is controlled exclusively by monetary policies of the Fed, or whichever central bank) and generalized liquidity therefore elasticity in finance and economy. Something else is going on, much of what matters remaining hidden (shadows).

Realizing this repeating truth has propelled a few of the braver souls into the depths of the monetary plumbing to try to figure out why. From here I’ll cite a couple efforts, a pair of recent (relatively) papers published by the usual mainstream Economists in the usual mainstream places. And, as usual, they look right at these major issues without being able to see them.

Start with this admission from the first of the two:

“Frequent and acute dollar shortages pose new challenges not only for banks’ liquidity management but also for the implementation and transmission of U.S. monetary policy.”

Dollar shortages despite trillions in bank reserves. Imagine that!

Put out by the NBER in July 2020 right in the aftermath of that crisis, Correa, Du, and Liao’s paper titled U.S. Banks and Global Liquidity dives into the daily reports from six domestic G-SIBs, global systemically important banks. Their immediate purpose was to piece together just how these dealers intermediate during any “dollar shortage” situation.

What they “found” was dealer banks who borrowed via transfers from their siblings, depository subsidiaries lying within the same parent holding company structure. Hardly surprising behavior, dealers have been doing this since dealers and depositories were (unwisely) put together beginning overseas in the eurodollar system’s earlier days. Gramm-Leach-Bliley wasn’t really so much about better service for bank customers as it was letting dealer banks tap depositories’ funding, including collateral.

Either way, the authors recall how in the pre-crisis era before “abundant reserves” dealers would respond efficiently to the profit motive provided by basic monetary economics – rising spreads. “Short-term money markets were very integrated, as financial intermediaries were able to effectively arbitrage across different market segments in the absence of significant regulatory constraints on their balance sheet.”

And there it is, the same conceit and fatal constraint. The academics can’t figure out any reason other than government influence why “able to effectively arbitrage across different market segments” has been so disastrously disabled to the point trillions in bank reserves provide no effective backstop to the system. In their view, it has to be regulations.

Except, this same problem was witnessed – at the Fed – long before Basel 3 or even Dodd-Frank. During the 2008 monetary crisis, dollar shortage, no less, noted by officials on several occasions was how dealer banks weren’t arbitraging as they had been, as they are supposed to.

“MR. HILTON. Coming back to one of the other questions that Don had about what we are hearing about stigma from some of the banks, one of our better contacts, Citibank, as Jim mentioned, used to do a lot of arbitraging and using the discount window, the primary credit facility.”

Before even Bear went down, “That has pretty much stopped cold…” Then-System Open Market Manager Bill Dudley later confessed that the Fed’s dollar swaps were seeing more bids in Europe after US banks refused to “effectively arbitrage across different market segments” in the 2020 paper’s words.

This refusal has a mechanical component, one identified by the NBER researchers. In the post-crisis era, dealers respond to rising money spreads in repo or FX (swaps) by relending from their depositories who are sitting on piles of reserves the Fed created. The latter draw down excess reserves by transferring them via internal reverse repo (from the depository’s perspective).

From the parent holding company’s viewpoint, there’s no change in its balance sheet, an ideal (sort of) result when constrained by something. This is different from before ’08 when balance sheet expansion was preferred.

Before there were so many excess reserves, dealers instead would borrow in fed funds or via some other private market source in order to relend in repo or FX.

What goes right over the heads of these academics is, in this latter situation where bank reserves are unquestionably abundant, dollar shortages keep happening. Plural.

How can that be?

No one answers. Rather, the researchers are content merely to note the behavior of the dealers, depositories, and bank holding company parents as if the whole question comes down to, how do we make bank reserves more effective in this setup?

The real question, one already answered above, is, why did it seem to work so well before? Only too well, actually, all that inter-market arbitrage putting enough liquidity into the global environment leading to all that previously massive credit expansion before 2008 (contrary to popular belief, credit expansion has been at most minimal since, primarily due to these repeatedly liquidity problems never solved by any QEs).

This brings me to the second paper, published more recently by the BIS last month (thanks Emil!) Afonso, Duffie, Rigon, and Shin (How abundant are reserves? Evidence from the wholesale payment system) look at the inner workings of the Fedwire system again in this post-crisis age of abundant reserves. As the quartet begins, everyone previously thought reserves would be the decisive factor in how the settlement engine functioned.

Not so:

“In the era of large central bank balance sheets, it has been conventional wisdom that the reliance of banks on their incoming payments to make outgoing payments would no longer apply because banks hold abundant reserves at their central banks. However, we find that, even in the era of ‘ample’ reserves, the amount of payments that a bank makes in a given minute depends significantly on the amount of payments that it has received over preceding minutes, indicating a high degree of dependence between incoming payments and outgoing payments.”


“The system as a whole is less reliant on daylight overdrafts provided by the Federal Reserve, but the decisions of individual banks continue to reveal significant balance-sheet liquidity constraints.”

The fact that banks have ready access to bank reserves via whichever means only means they no longer have to use so many daylight overdrafts (a condition in these settlement systems where the Fed, essentially, covers any shortfall beyond the prefunded balance of an individual bank but only during the day; that bank has to settle it by the end of the session, paying back the Fed). All other factors continue to be governed internally; banks don’t just use reserves like drunken sailors as proposed in the popular imagination of “QE money printing.”

In fact, two decades too late, the academic community is only now figuring out what was apparent from the very first instance of “quantitative easing”; that it isn’t quantitative nor has ever actually been easing (at least not in most respects of conventional understanding).

Policymakers knew this from the start, too, as Alan Greenspan blurted out in June 2003 when discussing Japan’s earliest QE’s failures:

“CHAIRMAN GREENSPAN. They have a broken banking system, and they are dealing with an economy without other essential financial intermediation.”

Quite ominously, the “maestro” then said, “We’re going to learn a good deal about how that economy functions in the future” without essential financial intermediation. And while he was speaking about Japan, he was actually talking about the global future from August 2007 forward.

Banks, particularly dealers, don’t need bank reserves. They didn’t before 2008. Sure, banks will use them if there are some around, as the NBER folks show, but if there’s something they want to do they’ll find a way to do it with or without the Fed’s (or BoJ’s) interbank tokens.

What matters most is balance sheet capacities which are governed by internal factors (including collateral availability, something no one ever deals with; the word never appears in any of these missives) far more than regulations and government policies. Banks in Japan weren’t subject to Basel 3 or Dodd-Frank, either, but were repeatedly subjected to the same money shortage situations as Spence Hilton was discussing around April 2008.

Among the most potent of those internal considerations are volatility and correlation. Nothing will kill balance sheet capacity quicker than heightened volatility (often accompanied by a rise in perceived/implied correlation). When that happens, like 2011, forget bank reserves entirely.

These dollar shortages come and go solely on the considerations of the banking system, the real money creators. Bank reserves don’t factor in either situation: when banks are creating money, they don’t need the Fed; when they aren’t, the Fed’s tokens won’t add anything.

Knowing whichever central bank’s policies aren’t effective (“new challenges…for the implementation and transmission of U.S. monetary policy”) only adds to the uncertainties embedded within volatility and the rest of balance sheet considerations (like perceived liquidity risks, for one).

Throw in the prospect of a nasty recession after the gross imbalances (including unreckoned economic destruction in 2020) of the past few years, what happens to inferred volatility? There’s your epic curve inversion(s) right there.


And if those are right, oh boy, we’ll be awash in QEs, bank reserves, and dollar shortages all at the same time all over again.

Jeff Snider is Chief Strategist for Atlas Financial and co-host of the popular Eurodollar University podcast. 

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