The Long Shadows

The Long Shadows

The news was one of those instances when you could see they were trying a little too hard. It didn’t make any sense, not anyway in the context to which it was delivered. On September 21, unnamed German officials were supposedly championing a megamerger in the banking sector. The country’s two largest financial institutions might be brought together to save Germany.


Just talking about Commerzbank and its bigger compatriot Deutsche Bank is fraught with nervous energy. It was a bit too cute, however, in that officials are trying to argue that it makes sense to do this now so that the combined whole would supposedly keep the German economy liquid during the next downturn (far off into the future, of course). A matter of prudent planning, you see.

Sure, a bank whose stock was down more than 35% for the year at that point, which had lost 76% of its value since January 2014, this was the firm to which everyone else would anchor so that everything would be fine for the next crisis? That trial balloon could not have been more transparent nonsense.

Deutsche Bank’s shares had been on something of an upswing before the news, but have cratered to new lows after.

Three days before that fun, Moody’s had put an interesting twist on international funding. The ratings company admitted what pretty much everyone had figured out by then. India’s biggest shadow financier was creating enormous and unappreciated (perhaps unaccountable) risks for the entire Indian money system.

One particular asset challenge for banks in a potential IL&FS default comes from the company’s complex corporate structure, which could result in high variation of ultimate losses across banks depending on where the banks’ specific exposures lie.

The shadow player is turning out to be a lot like other firms which had previously achieved similar infamy. They are deep and complex, and you can’t always tell how their increasingly likely downfall will play out beyond the specific company’s own reach. IL&FS hadn’t been designated a systemically important financial institution (SIFI) but the way India’s government has been reacting to the affair doesn’t require this one kind of official stamp.

The week after that, on September 26, the policymaking body of the Federal Reserve (FOMC) voted for a “rate hike”, its third of 2018 and the fourth over the course of the prior ten months.

Guess which of those three is being scrutinized the most for what happened in October.

The world briefly flashed into the shadow world ten years ago. In the decade since, ¯\_(ツ)_/¯.

Back toward the end of January 2018, while the dollar was still falling and the mainstream still filled with hysteria about inflation, hawkishness, and an unstoppable global recovery, I wrote:

That doesn’t mean that DXY and other dollar indices won’t keep falling; they very well might break new multi-year lows just as Treasury yields at the long end break multi-year highs. In both cases, these prices/indications/rates/yields are being moved by what is seen with only some occasional reference to what isn’t (more so in UST’s than DXY). It’s the stuff that isn’t that gains my attention not because it could push the dollar index up tomorrow in a hard reverse, but because it suggests the chances of another “rising dollar” shortage or squeeze are far higher than trivial – those times when suddenly ignoring the shadows becomes impossible any longer.

The first global stock liquidation would strike a week later, and now in the middle of November the shadows are everywhere. Everyone can, of course, continue to ignore what’s going on in them but the world at large cannot.

The dollar’s reverse in 2018 ends the fantasy of 2017; that the “falling dollar” last year was a return to normalcy after a decade of struggle. It has proven, quite predictably, to have been nothing more than the third reflationary episode (and not even that much of one).

In more recent months, the latest leg in the “dollar’s” disruption gets back to something going on in mid-September. LIBOR, for example, broke out of its prior multi-month range on September 20. In the last few weeks of October, 3-month LIBOR has once again “outperformed” its related UST yield meaning that TED is back from quiet obscurity.

Are these market jitters of a more aggressive FOMC as Jay Powell gains evidence for his case? The UST and eurodollar futures curves sure don’t believe it. Rising liquidity risk would have something to do with the global shadows where there are actually plenty of candidates for catalysts, not just the two examples I chose above.

These have been ignored in much of the media because most regular people only pay attention to the stock market. It’s hard to make the average American, let alone European or Brazilian, care about GC repo rates and the utter humiliation of IOER; until the S&P 500 suddenly drops for “no reason.”

While the President now blames the Democrats’ retaking of the House for Wall Street’s recent woes, after himself being blamed for heated trade war stuff, the effective federal funds rate broke to a new shallow spread underneath IOER on September 24. This has nothing to do with the “rate hike” that would follow three days later, rather the spread to RRP normalizes EFF within the policy frame of reference so as to pose a much different conundrum.

What’s going on in the shadows?

For EFF to get out of hand like this, and remain a painful reminder despite the Fed’s “technical adjustment”, it must be a pretty big disturbance. One of sufficient disruptive capacity that it would register in federal funds, an irrelevant throwaway market in these brave times. So much so it has come out in another growing alarm:

Interest rate swaps and their spread to UST yields (the swap spread) are a lagging or at most concurrent indication of monetary and financial disease. These spreads didn’t really come into the panic picture until almost right before Lehman. But once they turned, they’ve been a consistent indication of deeper monetary distress, systemic deficiencies that officials haven’t come close to solving (or even recognizing, which would actually be the required first step).

For the 30-year swap spread (and the 10s) to have compressed since mid-July, a four-month break in the reflation trend, indicates only growing negative pressure in the world’s reserve currency regime. The dollar gets all the attention as it rises, but it’s the eurodollar lurking in the shadows where it is all going wrong. Again.

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