Submitted by Jeffrey Snider – Alhambra Investment Partners
There is a great danger to negative interest rates, one that is denied by economists and central bankers because they deny the essence of wholesale finance. Stuck in the 1950’s, their solutions were arguable even then but hold little if nothing of value now. Markets are being reacquainted once more with the possibility (finally). As discussed last week, the Bank of Japan did not unleash more “stimulus” but rather confirmed the ineffectiveness and general impotence of all that came before (which was considerable).
Confusion over terminology is very much understandable in this area on the grounds of complexity alone. However, even in basic concepts there is in enough instances serious ambiguity as to render little but further confusion. In this case, surrounding NIRP, we have the simultaneous distinctions of the “dollar” short and a dollar shortage. While seemingly indistinguishable by virtue of the words’ common root, those terms are very different at least insofar as they can describe opposite perspectives. And it gets even more confusing when attaining those different perspectives requires an indirect angle.
On the one hand, the “dollar” short suggests nothing on its own of a dollar shortage. Indeed, the entire banking system from the first appearance of fractional lending shows that a systemic short position can be entirely stable for long periods of time. Any fractional reserve bank is synthetically “short” money; thus the difference between the short and the shortage was the willingness of the public to maintain equal value in claims. The short is the system, the shortage when it doesn’t work. This is “sound” banking or even “sound” money; the strong dollar.
The short turns to shortage when that confidence is eroded just enough to surpass some critical threshold. Once demands placed upon banks to deliver money become too voluminous, the money short becomes the self-reinforcing shortage – the bank run that leads to a systemic run. The point of the central bank under currency elasticity was to interject currency at that critical moment, so that the shortage might be undercut to allow the short its return to stability (artificial as it may be).
While that is much easier to follow, the wholesale “short” is a degree of magnitude further removed and in several important respects. The angle of perspective is no longer purely banks to the public; in the wholesale framework, especially the eurodollar, banks are “short” each other as well as the public. It is the interbank tangle that so perplexed “elasticity” in 2007 and 2008 as the public largely sat out the affair being stung almost exclusively in asset prices rather than money and convertibility. Outside of a few small outliers (Northern Rock), there were no long lines at ATM’s expressing the public’s growing unease with their perceptions of the currency regime. It was entirely an interbank affair.
The idea of convertibility and short or shortage is tied closely with past regimes which were reducible to something specific, usually money. The eurodollar system is quite different in that various facets can undertake such centrality at any specific moment in time, or even all at the same time. As I wrote in April last year:
To appreciate the significance is somewhat difficult because we are not talking strictly about money and currencies, though that is the subject matter. The eurodollar standard encompasses the dollar, or “dollar” as I think a more apt notation, but it is really the elevated and central expression of the wholesale model of finance. It spans the globe and forms the central axis by which the entire financial/economic framework is managed. In that sense, currencies aren’t as much currency, and surely not money, but nodes in a network of ordered arrangements.
Thus, convertibility doesn’t apply in the traditional sense but rather as methods of reconciling assets and liabilities; leverage ratios and mathematical calculations of “capital” and even P&L. What keeps the “dollar” short stable and operable are these multi-dimensional forms of numbers that allow firms to balance their books each and every night.
But if the balance sheets that hold assets are subject to the “short” and then the shortage, so, too, is the banking system meant to provide the resources. A bank that holds $50 in currency in its vault against $100 in deposit claims might be twice diluted, but what do you call a bank that has the same $100 in deposits against $50 not in vault cash but in other claims against other banks? That bank is “short” in both directions. The public-facing short is stable until the public turns deposits into cash; the interbank short is stable until any number of traded liabilities no longer satisfy mathematical calculations (and then trigger very human, if professionally human, emotion).
What happened in the Panic of 2008 was that only one of those directions panicked; the interbank one rather than the public. It was a bank panic of only banks.
We seem to have arrived at similar conditions in 2015 and 2016, only the slope of the discontainment is much, much shallower – for now. In an effort to further forestall that descent, central banks have continued with “stimulus” only now seemingly less smitten by the prospects of yet more QE. That has left negative nominal rates as the only option to be held out as “something new” (though not so much in Europe where the condition has been reversed).
With Japan openly moving in that direction and the Fed perhaps altering its strategic policy language, it seems as if NIRP may be more of a general tendency than policymakers might have suggested as late as late last year. Negative nominal rates present several challenges but perhaps none more so than the banking system itself and this one half of the “double short” preservation. It is not so much an interference or motivation for convertibility of the public’s appetite for holding deposit ledger balances but rather it presents material alterations (potentially) in wholesale dynamics.
For one, it acts as a tax upon those that might actually provide money dealing balances that aren’t being traded into easy and sustainable flow as it is. But more than that, at some unknowable threshold there is the potential to trigger convertibility in the interbank sense – why hold “excess” funds in interbank balances (currently Eonia or Euribor; shortly Japanese and then, maybe, federal funds and LIBOR?) at negative rates? It only makes sense to do so up until the costs of the alternative equalize with that negative rate. Fortunately for the wholesale system to now, those costs are not just interest rates as there are several avenues of resistance or friction holding ledger currency in place.
This was the central focus of speculation (on my part) of that April 2015 post, as I wondered aloud as to what might trigger inward convertibility.
What is important here is whether or how much that efficiency premium is durable. The unspoken option is for banks to convert those ledger balances yielding negative numbers into actual, physical cash. Again, they resist doing so because there is a cost to it, not just in terms of figuring out in the physical world how to transport and store billions of euros in actual currency, but in taking that option such “vault cash” is no longer directly connected to the wholesale system; ridiculously, that means that cash liquidity is no longer truly liquid. To this point, they are not willing, apparently, to go that far which suggests that we haven’t reached a point where the artificial, central bank-induced cost of not doing so is high enough – yet…
Instead of paying, say, -50 bps (or -100 bps, -200 bps?) and certainly not lending, might banks opt for convertibility despite the inconvenience and cost of doing so? It wouldn’t be easy, as how would a large-scale global bank quickly turn to storing €20 billion euros in vault cash, but I don’t think you can so readily dismiss that possibility. If one bank did it, then another might and then you have a good, old-fashioned bank run as convertibility of liabilities would be just like it was 1930 or 1893. [emphasis in original]
The main idea is that banks will “pay” interest for their liquid assets for the convenience of wholesale liquidity but only so far that wholesale liquidity might at some point accomplish something positive. You pay the negative rate “tax” because you hold out hope that at some future date, not too long into the future, true financial opportunity will again be regained – where ledger currency can sustainably and reasonably give way to actual investment and lending again. If there is little hope of said future, where faith in central banks starts to truly reverse or die, then why bother paying for the privilege of staying connected to the wholesale “liquidity” regime? That was the reason for these money markets in the first place; for banks to rid themselves of actual vault cash which can only ever be idle.
But what if ledgered money market balances are similarly idle and now costly? The European experience with negative nominal rates presents just that evidence. NIRP hasn’t accomplished anything like “portfolio effects” but instead proving that banks are only idle in terms of “liquidity.” They are already paying greater costs for the wholesale connection, so we have to assume they continue to do so because of their continuing faith in the opportune future. What about now? What point do they give up in favor of self-preserving disintermediation?
With Japan now in that category and hints of US policymakers already disseminating through similar whispers, you have to wonder how much NIRP has been game-planned and simulated by banks – especially eurodollar banks whose balance sheets are exposed in all these virtual currency realms. If that is a realistic option then once it starts it will have the effect of making the short into the shortage – converting interbank balances into physical currency will be a further direct drain upon active liquidity.
I have no credible knowledge or information that this is already taking place, but I have to question why physical dollars have been disappearing around the world since the middle of last year. Intermittent stories have sprung up suggesting a shortage of physical dollar currency and the idea that is only related to the oil price collapse, or even the general trade collapse, is uninspired and incomprehensive. It would be curious even in a world that hadn’t long ago left behind physical money (gold) or currency as a means for settling international trade and finance.
I have to emphasize that this is conjecture on my part, based only upon the curious nature of physical dollars seemingly disappearing from all over the world (not just Nigeria and China, but use in Venezuela, Argentina and others so far). Maybe this was to be expected, however, if eurodollar banks are no longer providing fluid and liquid use of the intangible eurodollar form, the new kind of interbank money that so perplexed the Fed throughout the 1960’s (and 1970’s, and 1980’s, and 1990’s,…). At some point in that deconstruction global banking might have no choice but to revert to its physical precursor – the eurodollar market might deny you a repo rollover but a physical Federal Reserve Note is under no obligation of any kind so long as you can get your hands on it.
The problem with NIRP is that it erodes even more the factors holding the ledger system of eurodollars in place. Not only is there the problem on the cash borrower side of the interbank, wholesale system (as noted in the paragraph above) but a similar quandary for the cash “owner”: why bother lending in repo at a sufficiently negative rate when it might be easier and less costly to just convert those positive but virtual interbank balances to physical cash and sit out the storm. In other words, if your only choices for otherwise idle cash (in virtual ledger form) are seriously negative central bank accounts (deposit account at ECB or perhaps a negative IOER?), seriously negative unsecured (Eonia, Euribor now, federal funds, LIBOR in the future?) or seriously negative secured (repo), then why bother with any when cash might be the least worst option. In a world losing faith in the central bank-inspired future, it might not even be least “worst.”
The point is not whether this is likely but rather that it is entirely possible and that central bank desperation might wander too far. It is a corollary to the “nightmare” scenario; where engaging in wholesale tactics is the entire problem. The solutions, then, become the means of only further problems. In the case of NIRP, there is the potential for “stimulus” to not only backfire but do it in spectacular(ly awful) fashion. Until we figure out where all those dollars have gone it remains a legitimate concern.