By Jeffrey Snider, CIO, Atlantic Capital Management of Florida:
In a world awash with digital fiat money, this constant need for liquidity measures is sometimes hard to reconcile with the sheer amount of digital monetary units created in the months since October 2008. But real liquidity is far more than quantity. When the banking world was in danger of falling apart in early December 2011, central banks around the world got together to coordinate a liquidity response to growing illiquidity under conditions of prior extraordinary liquidity measures. The chronic shortage of dollars in this “recovery” period gets most of the attention, and it did again last December as the Federal Reserve reduced the “penalty” rate on its open-ended dollar swaps to 50 basis points (from 100) over the Overnight Index Swap rate. Not long after that, the European Central Bank stole the liquidity show by announcing its intentions to conduct Long-Term Refinancing Operations (LTRO), extending central bank liquidity measures to the unprecedented (and at one time unthinkable) maturity of three years.
Lost in that massive shuffle was the Bank of England. On December 6, 2011, England’s central bank announced:
“In light of the continuing exceptional stresses in financial markets, the Bank of England is today announcing the introduction of a new contingency liquidity facility, the Extended Collateral Term Repo (ECTR) Facility. This Facility is designed to mitigate risks to financial stability arising from a market-wide shortage of short-term sterling liquidity.”
It was a typical, wholly uncontroversial statement that the central bank was standing by, fully equipped to put out any interbank fires denominated in sterling. The Bank was quick to add in that release:
“There is currently no shortage of short-term sterling liquidity in the market.”
It was more than a little curious to find an announcement from last Friday, June 15, 2012, that activated the ECTR for its first sterling auction of £5 billion, carried out this past Wednesday. The most important part of the ECTR as it relates to liquidity conditions is its notable relaxation of collateral standards. This liquidity measure significantly increases the types of collateral the Bank of England will accept at this Discount Window bypass. Reports have indicated that other liquidity programs that accept only high-quality collateral have seen muted demand this year, meaning we have a potential hoarding problem brewing now in the British currency.
We knew this was the case for both euro term and euro overnight funding, as the LTRO’s themselves were committed with collateral relaxations embedded for firms operating in the national central bank jurisdictions of afflicted nations (Germany was notably absent from list of national central banks that relaxed collateral standards, but France was not). This fits in with the theme that the derivative interbank currency, quality collateral, was in desperate short supply to the detriment of overall liquidity conditions on the continent. This was not surprising to anyone paying attention to European interbank operative conditionssince the process of redefining the quality collateral list has been ongoing, and largely uninterrupted, since the summer of 2007.
That collateral problem even extended into U.S. dollar repo markets, a condition that was exacerbated by the Federal Reserve and its QE 2.0-related depletion of available on-the-run U.S. treasury bills. By April 2011, U.S. dollar funding conditions had worsened to the point that treasury bill yields were often negative thereafter, a dangerous condition for credit markets.
In 2012, we have seen similar circumstances from Switzerland to Germany. However, collateral issues in sterling funding have not, to my knowledge, been an issue at all. The fact that ECTR was activated this week, at an extended six-month maturity no less, is downright curious. For most of this week we have heard the rumors of big UK bank downgrades added to an already stressed funding environment that saw the LCH increase margins on Spanish and Italian debt. Is there enough here to link all these together and assume the big British banks are now being pulled into the vortex of PIIGS exposures?
Perhaps, but that may be a bit premature. Something, likely several somethings – none of which are remotely positive, are continuing to roil beneath the surface of the global financial system. The LTRO/Fed dollar swap liquidity fiesta of late 2011/early 2012 certainly hid this deterioration in the investor euphoria of monetary anesthesia. Part of that euphoria was certainly some misplaced relief over the ephemeral possibility that the U.S. economy might actually grow into a recovery. For the most part, though, interbank conditions never really fully recovered from the near-nightmare of last autumn.
At this point in the crisis cycle (which has yet to reach an apex; or nadir dependent on your perspective) it has gotten extremely difficult to ascertain anything of significance in these vital monetary sectors. That is a stark contrast to the aftermath of the Lehman bankruptcy, on Monday, September 15, 2008. That day, all sorts of meaningful interbank indications went absolutely crazy. Three-month financial commercial paper, which had been relatively stable between 2.6%-2.7%, jumped to 2.86%. Three-month eurodollar deposit rates, again having held steady in a tight range of 3.3%-3.4% throughout the year, blew out to 4.04%.
Most importantly, the effective Fed funds rate (the overnight rate banks trade excess reserves on an unsecured basis) opened that fateful Monday at 2.64%, 64bp above the Federal Reserve target of 2%. The next day, the effective rate was back to the target, before jumping back higher, this time to 2.80% on Wednesday, September 17, 2008. On Friday, September, 19, 2008, however, the effective Fed funds rate stood at 1.48%, or more than 50bp below the target! By September 26, the effective Fed funds rate dropped to 1.08%; almost a full percent below the target rate. For the next two weeks, the effective rate gyrated from well below the target rate to 2.97% on October 7, sparking the Fed to finally reduce the Fed funds target by 50bp to 1.5%. For most of the rest of 2008, until ZIRP was instituted that December, the effective Fed funds rate traded well below its target (for example, on October 31, the effective rate was 22bp compared to a 1% target rate). It was absolutely, painfully clear from these indications that domestic interbank money was in disarray.
Over in London, 1-month U.S. dollar LIBOR (a measure of unsecured lending of eurodollars) was rather well-behaved on Monday, September 15, 2008. For the entire summer up to that day, 1-month LIBOR traded in a very tight range of 45bp-49bp over that Fed funds target of 2%. While the Federal Reserve does not have any direct authority over the eurodollar market, the behavior of LIBOR rates, as many studies have suggested, is very strongly influenced by the Fed funds market and Federal Reserve policy. This is as you might expect since these two markets can be arbitraged by global banks that transfer cash to and from U.S.-subsidiaries/parents. In effect, what this means is that the Federal Reserve can exercise control over the eurodollar market while at the same time denying any responsibility for it.
On Tuesday, September 16, 2008, however, 1-month LIBOR broke its tight range and ran up to 2.745%. Three-month U.S. dollar LIBOR was slower to react, only rising about 6bp that Tuesday, but began to rise a bit more by Wednesday. By September 30, in contrast to the Fed funds effective rate, 1-month LIBOR was an astounding 3.92%, or almost 150bp above its range, joined by 3-month LIBOR at 4.05%. By October 10, 2008, 1-month LIBOR stood at 4.5875%, while 3-month LIBOR registered 4.81875%. Over the same period, not coincidentally, U.S. dollar asset prices crashed, including U.S. stocks.
Three-month LIBOR for pound sterling, on the other hand, rose only a small amount during the crisis period: from a range of about 5.7%-5.75% before Lehman to an apex of 6.3075% on October 1. Three-month LIBOR for euros behaved almost exactly as the terms for interbank sterling, rather than eurodollars. Where there was money to be lent in Fed funds (domestic U.S. dollars overflowing in the hands of GSE’s), sterling or euros, there was nothing to be had in eurodollars. The 2008 panic was centered in Europe, and it was a shortage of dollars for global institutions that “hub and spoke” into the London market for U.S. dollar denominated assets.
liquidity issue was apparent to anyone who wished to look. Interbank lending was often conducted on an unsecured basis in those days, but has completely collapsed for anyone outside of the largest institutions since. US dollar LIBOR barely moves anymore. From the end of August 2011 to a peak on January 3, 2012, 3-month US dollar LIBOR rose from 25bp to just over 58bp. Starting in December 2011, the Federal Reserve’s dollar swap usage rose from nothing to just over $100 billion by early January 2012, suggesting that eurodollars were in far shorter supply than indicated by those LIBOR rates.
This liquidity issue was apparent to anyone who wished to look. Interbank lending was often conducted on an unsecured basis in those days, but has completely collapsed for anyone outside of the largest institutions since. US dollar LIBOR barely moves anymore. From the end of August 2011 to a peak on January 3, 2012, 3-month US dollar LIBOR rose from 25bp to just over 58bp. Starting in December 2011, the Federal Reserve’s dollar swap usage rose from nothing to just over $100 billion by early January 2012, suggesting that eurodollars were in far shorter supply than indicated by those LIBOR rates.
Recently, from April 24, 2012 to now, 3-month US dollar LIBOR has moved a grand total of 0.002%, or two-tenths of a basis point.
For euros, 3-month LIBOR grew steadily throughout 2010 and 2011 as the crisis morphed from U.S.-dollar mortgage products to sovereign PIIGS debt. The contagion of this crisis period has not been simply bond prices as conventional monetary thinking has understood it, but in the evolution of how we understand all financial risks (more on this below). This is a change in the very character of the system itself, allowing systemic contagion, for lack of a better term, to jump from completely unrelated sources: the mortgage bond problem of eurodollars is now a PIIGS debt problem of euros. It is exceedingly hard to be successful building monetary firewalls when you do not understand the exact nature of the contagion spreading throughout every pocket of the global system.
But for all the danger that was apparent late in 2011, the peak in euro LIBOR terms came not in December or January 2012 when the LTRO’s were forced into existence by growing illiquidity, the top was actually registered on October 31, 2011. Euro-denominated LIBOR has been falling steadily ever since, through the worst European days of November and December of last year. Even now, in May and June 2012, as Spain and Italy are again beset by credit “vigilantes” and bank failures, euro-denominated LIBOR terms continue to decline.
Unsecured lending in almost every major currency is, for all marginal intents and purposes, dead beyond the largest global banks. That leaves nothing more than secured lending (repos) as the source of operational funding. The relative sanity in unsecured wholesale markets is a reflection not of successful monetary policies and “normal” liquidity conditions, but of the effective liquidity desert that reigns in the rest of the system. This is the mark of the failure of monetary policies from coordinating central banks to address basic liquidity issues almost four full years after the panic (and nearly five full years after the first concrete indications of crisis in August 2007).
Rather than serve as a means of financial salvation, all of these interventions serve to diminish the state of vital financial information. There is not very much or very good information about the non-uniform state of the repo market or true systemic liquidity as they exist today. We can only glean anecdotal information that comes in snapshots of “outlier”-type events. Thus, the ECTR activation coming now may signal a vital change in the downward slope of global liquidity. Putting together various snapshots we start to see a crisis that is further spreading, not abating as was expected after the massive and unprecedented nature of the LTRO’s. Hoarding of “good” collateral or the movement of money to Switzerland are both indications of very desperate trouble that remains just out of view.
For all the extraordinary measures central banks take to try to finally solve this unending liquidity puzzle, they never breach the flow issue. They can create money to infinity, but they will be damned if they can get even the slightest amount to circulate. All of the theories and policy channels that exist at central banks are incapable of addressing these flow issues. Part of that is the technical nature of central banks themselves. The Federal Reserve, for example, was not set up to render emergency liquidity to non-depository investment banks despite the fact that those same investment banks were almost fully responsible for all marginal credit in the past two decades – by the design of central bankers themselves (just a small oversight, I suppose). For its part, the European Central Bank is essentially an ad hoc institution that doesn’t always have a good enough sense of its own role in the monetary curvature of individual states (an accurate reflection of the badly misconfigured currency it serves). But beyond these technical shortfalls lies just plain bad theory.
Quantitative easing itself was always a two-part process, for example. Step one was to create money, but step two was to get it circulating. The problem here in the U.S., as elsewhere, is that the only method for circulation that the Federal Reserve has in its theoretical and operational arsenal is inflation expectations – it is ill-equipped for any other means. As it takes intangible measures to create positive inflation expectations (along with just the passive expectations that come from the creation of money itself), the Fed then expects (hopes) those inflationary expectations combine with ultra-low or zero bound interest rates to result in negative real interest rates. The only real monetary tool for the Fed is a choice to extend negative real rates out the yield curve as far as its models say is optimal (Operation Twist is a program of influencing negative real interest rates further down the yield curve). Unfortunately, that operational variable locks the Fed further into its own policy errors since it gives policymakers an outlet for failure: they can keep changing the maturity variable instead of scrapping the entire model.
As it is, the theoretical understanding of liquidity and real economy circulation for monetary policymakers is based on the data set of the previous four decades, concluding that inflation expectations are enough to get “money” flowing. However, the reality is that previous monetary channels are dead. As this relates to the banking system, there is no way to circulate massive amounts of central bank fiat money without sufficient financial collateral, an aspect that was certainly not contemplated when the first Basel rules were debated in the mid-1980′s. But as markets redefine what constitutes “quality” collateral, the natural implosion of circulation is reinforced by the uncertainty created by that very lack of circulation, a further element that was not anticipated by the monetary textbooks nor the data series the whole system is based on. In a very surreal manner, central banks can create money, but seem to ignore that fact that something needs to create interbank money. What central banks need is not cash as commonly understood, but interbank currency that can be used to satisfy the terms of uncertain counterparties in the process of freely circulating existing stocks of cash and credit. Central banks should ditch these money stock measures to focus solely on means to increase flow, but that would require a dramatic shift in how modern monetary science views its operational and theoretical framework.
What drove this liquidity pressure into the arms of insolvency is the modern global banking system’s arbiter of credit production: bank capital. Banks are stuck with government bonds as collateral (just like they willingly loaded up on mortgage products rated AAA) because the system engrained preference on certain credit securities at its inception. OECD sovereign debt was given a systemic seal of approval with a zero-risk weighting to equity capital back at the start of Basel. Basically, what all this boils down to is an idea that we can accurately measure the risk of the financial system, and have ultimate faith in that measurement. Banks followed this path enthusiastically since it meant that they could use this regulatory leverage to make even more money, including conspiring with accounting conventions to create new classes of regulatory preferred collateral candidates. Investment banks, Wall Street and eurodollar London, were especially enthusiastic because they now had a very real advantage over traditional depository institutions – regulators were intentionally favoring this kind of system since they believed it provided a means of control over the real economy (and it adhered to their mathematical ideas of quantifying everything), yet no one bothered to plan or map out potential fail points outside of the date sets.
Central banks have been stunned by the turn of events outside their mathematical predictions and recency bias, but rather than moving beyond their assumptions that have proven very false by events, they continue to adhere to the same playbook as if it were still 1988. Rather than move beyond convention, central banks simply want to re-establish the illusion of control – a condemnable goal.
Unfortunately for all of us, the devolution of the banking system has brought it into a state of not only perpetual crisis beyond the reach of conventional monetary means and theory, but into a new dark age. At least in the worst days of 2008 we knew pretty well what was happening and why. Even as early as August 2007, we had a very good idea about what was occurring, and could extrapolate those very open indications into real expectations. In 2012, it is exceedingly difficult to get an exact pulse on what is going on anywhere, except the ultimately useless public acknowledgements that bank operators and central bankers still fully believe they can easily control all of this; all the while it spirals into greater and greater dysfunction. The danger here is that the next major phase shift in this complex system simply appears without warning to the overly complacent population of financial actors, especially policymakers that continue to act two decades behind the curve and are always mystified that this economic malaise will not conform to the inflation expectations theory of flow (just this week we had the JOLTS survey and the Philly Fed survey confirm inaccuracies in that script).
While we try to accumulate the anecdotes and snapshots of disturbance, the true state of the financial mess remains dangerously hidden, as if we needed more challenges in this day and age. But, like the Sword of Damocles, the eurodollar overhang remains just above our heads, poised to fall as all that disruption in euros, and now, apparently, sterling, threatens the only tether to stability that exists in such an agitated state: a freely functioning financial market that exhibits true price discovery. I would prefer the LIBOR’s be at 5% again and reflect something meaningful, than for them to be at near-zero and be utterly useless indications as the system devolves anyway. Ultimately, the truth gets out.