Andy Kessler recently wrote an opinion piece for the Wall Street Journal on the “shadow banking system” based on research by Jeff Snider of Alhambra investments. Snider’s work is complex and impressive. He has astutely tracked this hidden side of finance for years and routinely warns about the threats it poses to financial markets.
Snider’s insight is nothing new. Its appearance in the pages of the Wall Street Journal is.
The Journal is not a canary in the coal mine. By the time an event is news in the Journal, its consequences are already working their way inexorably through the financial system and global economies. Snider was forewarning; the Journal is notification.
The Global Funding Problem
Kessler captures simply and succinctly the incredibly complex research that Snider routinely posts to the Alhambra site. A mainstay of his work is that the world does not have enough U.S. dollars. Since dollars are the currency (in effect, lingua franca) of international trade, the global economy requires dollars to grow, just as any economy needs an expanding money supply. Germane to this system, which Snider calls the Eurodollar system (as it is largely based offshore), is the repo facility. In the repo transaction, dollar-denominated assets are lent short term to provide the funding for meeting dollar-denominated obligations from international trade or otherwise. When there aren’t enough dollar-denominated assets around, funding dollar-denominated obligations becomes more expensive.
Most important is what occurs during times of financial stress. The Great Financial Crisis of 2007–09 is a case study in such instances. Mortgage-backed securities (MBS) were routinely used in the repo market as collateral for short-term funding. When questions arose as to the quality of those bonds, the markets rejected them for such transactions and would not lend against them. Overnight lenders chose to accept only “pristine collateral,” the predominant variety of which is long-dated U.S. Treasuries.
Growth of the U.S. sovereign debt is not simply a measure of U.S. government dis-savings. Since the dollar system is global by virtue of its reserve status, our debt serves as a balance-sheet item for banks worldwide. When the Fed engaged in QE (quantitative easing), it was attempting to bolster U.S. bank reserves (swapping U.S. bonds out for reserves).
What it also did, however, was constrict the supply of long-dated bonds that global banks were using for short-term lending. Despite the massive deficits our country has continued to run, the duration of U.S. debt has remained fairly short. The limited supply of longer term bonds, combined with the strong demand for them in short-term lending markets, has helped push prices up and yields down.
This is not the narrative that we get from the Fed. Its account of U.S. money supply and inflation is told with an eye largely toward the U.S. economy rather than the mechanics of the global financial system. The currency in which it deals, however, reaches far beyond our borders. Snider’s critique: The Fed is woefully ignorant of how the global financial system functions and the impact its policies have on that system. Therefore, negative knock-on effects from Fed policy are a serious threat to the global economy.
A Problematic Medicine
Kessler proposes a few remedies the Fed might employ to counter the pressures the current dollar shortage has placed upon the global economy. He basically advocates that the Fed issue longer dated debt and refuse QE. It soaks up the quality collateral the global system needs to churn as it facilitates trade.
In this scenario, bigger U.S. deficits are actually an opportunity to extend duration. It can sell longer dated bonds to give the market the collateral it needs. Issues with federal fiscal discipline aside, this approach runs into a problem highlighted by Luke Gromen, founder of the investment research firm Forest for the Trees.
The value of the dollar has been rising. President Trump hasn’t shied away from his displeasure with this development and whether or not his criticisms are well placed, the dollar’s strength is a problem for global funding markets. Global weakness, courtesy of the trade war among other forces, has seen global currencies weaken against the dollar.
The result is that foreign purchases of U.S. Treasuries have largely dried up because the cost of hedging against the dollar has increased to such an extent that the trade is no longer profitable. In fact, the negative rates in Europe can be read as a testament to how negative the carry is for foreigners who hold U.S. debt. Foreign investors lose less on a negative-yielding bund than a positive-yielding U.S. bond made more negative because of hedging costs.
The result is that U.S. buyers, including the banks that serve as dealers of federal debt, must pick up the slack. While the world is short dollars and cannot access dollar-denominated collateral economically because of the dollar’s strength against foreign currencies, the U.S. is digesting astonishingly large quantities of U.S. debt.
This is so much so that primary dealers—those required to buy U.S. debt by virtue of having the privilege of selling it to the public—may be straining their balance sheets to stomach the quantities.[1] In recent auctions, these dealers have been buying an outsized portion of the issuance. Gromen suggests that the Fed will re-engage its QE program to relieve those banks of the many notes they now hold in inventory. As Kessler points out, however, QE messes with the global dollar system. This is a snarled web indeed.
Caught Up in Complexity
The domestic stresses described by Gromen only serve to complicate the intricate dynamics from Snider as outlined by Kessler. The modern financial system is complex and so interconnected that knock-on effects should be expected. The fact those effects are unknowable, however, ought not sit well with markets, which prefer predictability. This is the environment in which the Black Swan thrives.
While they remain in the shadow, systems like the repo markets and the dollar-funding system were the mechanisms that spread the financial contagion of 2008. That only heightens our concern. They were the underbrush that accelerated the last financial forest fire. The fuel remains, and an inferno needs only a spark to be set alight.
That would make the valuation of financial assets matter in a way we haven’t yet seen in the QE era. For the record, the new Shiller CAPE (cyclically adjusted price-to-earnings) ratio is at 36.16 in September 2019, a valuation reached only in 1929, 1999, and January 2018. In the complex matrix of myriad negative macro-economic indicators, these dollar-funding stresses are merely the latest straw coming to bear against the historic hump in equity prices we see today.
[1] https://www.bloomberg.com/news/articles/2019-05-08/low-yield-bad-seasonals-and-trade-trip-up-u-s-10-year-auction