Have you ever watched the movie “Syriana?” If you haven’t seen the film or read the book it’s based on, “See No Evil” by Robert Baer, I encourage you to do so. The movie is adapted from the book, but the raw emotions both of them leave you with are still one and the same.
But emotion is not at the heart of this post. Yet this post and those two works share something: a way to connect the dots. Because make no mistake: the fiscal situation in sovereign Europe, short-term funding conditions, and that 1,000 point plunge on the Dow are all connected.
What is important is to understand the conditions that caused the crash to happen in the first place. If you peel back the layers of market activity from March 2009, you’ll find that the majority of the market’s surge occurred in overnight trading on virtually no volume. Similarly, away from the market, in the economy, virtually all real economic activity was replaced by government programs with incomes replaced by transfer payments. This had the effect of supplanting economic activity that had been sharply dampened by the deflationary force of too much debt.
The aspect I’m referring to is the use – and the abuse, in fact – of liquidity to foster stability in markets. We could extend that to talk about the abuse of liquidity in the economy at large, but that’s fodder for something else.
But back to the markets. A friend of mine on Twitter, Jeff McGinn, pointed this out in a tweet to me:
He was responding to my post here. I posited the idea that the much talked about (I don’t think we can say bally-hooed given the reaction) €750bn bailout was, well, falling flat. And that the next step could be to take that sovereign debt out of the credit markets altogether by forming a “bubble world” for it. Like a parallel universe. Or the island of misfit sovereign credits. I focused on one idea, he focused on another. But they do intersect, just stay with me…
He said LIBOR is not what it used to be. Now what does that mean? It means LIBOR – which is made up of a panel of banks – has been distorted with the trillions of Dollars, Euros, Yen, etc. thrown at it by central banks in the form of currency swaps, asset purchases, and everything else they’ve done. It used to be used as a proximate rate which a highly-rated counterparty (that’s not a government) would pay as its cost of funds. But with the programs we witnessed over the last year, can we really say any of them are “highly-rated” counterparties? A shake of the magic 8-ball would tell us “signs point to no.”
But there are consequence to all of that liquidity. Some of them intended, others, not so much. First, the intended consequence: it has caused those “highly rated” counterparties to chase risk. Which is what central bankers want because they are – as zerohedge put it today – “slaves to asset prices.” Indeed.
Now the unintended. To start, let’s look at a 5yr chart of the LIBOR-OIS spread:
In August 2007, spreads went haywire and just got worse. The Fed’s response was to throw enough liquidity at the problem to tamp it down. Rates were taken lower. Predictable, because that has been the Fed’s approach going back to Greenspan:
But that wasn’t all. There was all manner of balance sheet explosion:
Which brings me to the reason this is so dangerous: convexity. Here’s where you can say you got your fixed-income geek on (borrowed shamelessly from Wikipedia):
The point of the formula can probably be better illustrated here:
Since the biggest central banks have all pushed rates to 1% or less, convexity is magnified. A. Lot. If the yield curve was shifted higher…
The spikes we’ve seen in LIBOR rates, TED and LIBOR-OIS spreads would not matter as much. But they are and it does:
Central banks have led us down a path that ends with us being either trapped in a corner or at the precipice of a cliff. Choose your visualization accordingly, but it means we have to consider that there are no good options left. I wrote a recent post where I tried to characterized a new normal. Here’s a quote as it pertains to liquidity and credit:
What I see in these charts as well as the year-over-year charts is that V-shape which so many folks have wanted to crow about. Ok, fine. But consider the levels for a moment and all you see is that all the money we’ve thrown at the economy was to stop the complete implosion of credit. When looked at on a levels basis you can see there’s a long, long slog ahead of us.
But what I wonder is this: are we in for more volatility in economic indicators as Fed monetary policy response looks more and more like a” Twilight Zone” episode and less like central banking? And with what effect? What if all this stimulus, all this unorthodoxy in central banking does is – as a best case scenario – get us back to our last cyclical peaks in 2007? We would’ve replicated Japan. Richard Koo would be trying to convince us that was a good thing while I look at him like he is a three-headed cyclops. The image of a three-headed person just wouldn’t capture my level of bizarreness well enough.
The credit market is not just priced to perfection: it’s priced to the hilt. At these funding costs, credit creation could be almost unlimited. Yet what are we seeing? The charts I presented above. Illiquidity. Possible bank runs. Carry-traders getting the gas-chamber treatment as Euro-Yen trades blow up. Then there’s the stimulus to stave off bank failures, which gets recycled through abnormally high levels of risk-taking (i.e. moral hazard). The bailout machinery will be running 24/7. Kind of like the Shit Sandwich Deli was 3 years ago.
Zero Hedge was all over this today. The charts were compelling and the simplicity of the message was brilliant in my view. But I want to leave you with their final thought:
Our advice is as it has been since May of 2009: stay out of the markets except for gold. Gold is safe, as it is a direct bet on the stupidiy of our politicians and the lunacy of our money printers… which lately just happen to be one and the same thing.
I don’t necessarily agree with it, but I certainly do understand the sentiment. Why do I not agree? Simple. Because in my view, I think the gold/fiat currency dynamic has been simplified. Either this or that. We had problems with over-zealous credit extension (1907 bank run, Great Depression) under gold. Just like this cycle has obviously been more about the over-extension of credit than it was about true recovery. The real antithesis of where we find ourselves is barter: the absence of credit. Why would that occur? Because nobody believed anyone was creditworthy. And why would they think that? Because everyone would be perceived as being over-leveraged. No rating/rank-ordering system could identify good borrowers and separate the bad ones out of the pool.
So here’s my last question: how much of what I just described has happened already?
We’re closer to the edge than we think…