I want to follow up some recent posts I wrote on where we are and where we’re potentially headed. First, I want to offer two pairs of charts, some may be familiar but others may not. Take a look at the first pair: levels of M3 in the Eurozone and MZM here in the US:
My those sure look correlated. They show the growth of aggregate money supply over time. It should be noted money supply growth has plateaued and started turning negative in a pretty significant manner. These are 30 year charts showing the growth of money supply at an exponential rate. That trend has been broken. Rather decisively.
Here’s the same data, presented in annual growth rates:
The fact is these monetary aggregates are shrinking and that shrinking is accelerating.
The question is why. In a time where stability is but a pipe-dream, why are we seeing this now? Ideally, money supply should still be growing to foster, as central banks put it, “price stability” and its cousin “financial stability.” There’s one theory I want to explore, but I may not do a good job of it in any one particular post, so bear with me. I do have a train of thought, I promise. It just might take me a few posts to flesh this out and this is part of the process.
Recall our euro and dollar Libor spread curve where I represent the spread between the two rates as a curve:
The spread is flattening across the curve, and the only way I can see to relieve the pressure is to resume the issuance of central bank liquidity swaps, but so far there hasn’t been much borrowing…
I think we need to see this rise almost parabolically to relieve those funding pressures. Do we need $600bn like at the peak in September ’08? Maybe not now, but there may be a need for several hundred billion, as the real sovereign debt issuance is still ahead of us in the months of June and July. And the potential for banks to re-liquefy their balance sheets seems pretty high.
The question is why haven’t we seen more use. I have to credit Tom Keene with pointing me to this post from Stanford economist John Taylor. Anyone who has a monetary policy rule named after them garners my respect, but I have to admit I disagree with him a little on this post:
Note, however, that the recent increase—visible in the right part of the chart—is very small compared with the jumps in 2007 and 2008.
In absolute terms, yes. In levels of volatility, yes. But given the liquidity and money – in the form of debt, mind you – that has been thrown at these spreads as well as the rate cuts we’ve seen, it’s still disturbing to me. “Convexity kills” to paraphrase Al Davis’ well-worn expression “speed kills” in pro football.
But in the same post, Professor Taylor also gives us a possible reason why we haven’t seen more borrowing:
I have argued since the start of the crisis that the Fed should provide daily (not just weekly) balance sheet data so people outside the Fed can evaluate the impacts of its programs on the markets, but this is all we have. It is not clear why the loans have declined so rapidly. Perhaps criticism about participating in the European bailout led the Fed to discourage the use of the swap loans under the program at a time when the Fed is trying to prevent the Congress from reducing its independence. Or perhaps the interest rate (1.24 percent) was simply too high.
*Gulp!!* 124bps is too much to pay? That speaks to a very weak banking sector. Here’s a screen shot from the ECB of the operation:
Turns out, dollar funding has gotten a lot more expensive. 123 bps for a week. Last week, it was 124bps for 3mth dollar swaps. Either pawnbrokers have overrun the ECB, or more likely, the desperation in European funding markets is just getting more desperate. Bigger swaps, higher rates and shorter maturities. That’s not a funding market that is stable.
So in the meantime, dollar Libor rises:
Which, presents another problem:
If LIBOR continues to creep up and reaches, say, 75 bps, it no longer will be economical for banks to own US 2-year notes. In that case the US Treasury market will be in trouble. That’s when you head for the bomb shelter.
Make no mistake: traders playing a curve steepener strategy would be slaughtered like enemies of the Corleone crime family. So may I suggest another bear flattener? Start selling 2yr Treasury futures and taking down 10yr futures. Or, if you want to use an option strategy, buy 2yr puts & sell 10yr puts to give you some more flexibility. The CME Group has done a good job of outlining this in a strategy paper. I embedded it here:
So the bottom line is this: the quantity of money out there isn’t enough to subdue funding costs/risks. More is needed, but we’re unsure how much. So in the meantime, spreads between dollar Libor & 2yr rates need to be watched because we might see “The Mother of All Bear Flatteners” hit the market.
All against a backdrop where adding more liquidity probably won’t help…
Are we having fun yet?
Don’t think any monetarists are at the moment…