EDITOR NOTE: Are you ready for a load of central bank-speak with some translation? If you are, this article attempts to expose and explain the movements by the Fed and ECB to combat the deflationary scenario as seen through their models toward the pro-inflationary framework that defines monetary policy today--a framework whose unintended consequences we may have to deal with for years to come. The critical part of this article is the correlation between US bonds and German bunds. It’s a bit of a technical read. But if you’re able to get through it, you’ll see the missteps that central banks are currently taking to put both economies in a severely precarious position.
In the race to pretend to debase, Europe’s central bank has pulled ahead of America’s. The ECB’s balance of digitally-printed bank reserves is rising fast while the Federal Reserve’s reserves plateaued months ago. For the first time in its history, the Europeans claim “excess liquidity” (their term) in excess of €3.3 trillion and steadily rising.
In years long past, this “flood” would’ve unleashed howls of protest spoken primarily in the German language, the damning label “Weimar” thrown loosely around in even mainstream channels. Nowadays, barely a peep.
One big reason why is the constant and real flood of instead deflationary signals proliferating and rising. Where inflation - or at the very least early signs of inflation - are supposed to be, there remain only the opposite despite the ECB on the winning side of QE pacing.
Not just current measurements of consumer prices, either. Those are actually falling, by the way, with negative CPI’s (and HICP’s, as they do over there) growing more negative in October (-0.3% y/y; -0.5% in Germany). Even stripping away volatile (down as well as up) food and energy prices in Europe, the Euro Area’s “core” inflation rate was the same +0.2% year-over-year last month as it had been the month before (September).
Both months at record lows, in other words.
In the bond market, the bund market, actually, yields on federal German securities have been steadily sinking since late August. The 10-year constant maturity rate had gotten as “high” as -0.39% on the 31st but is now (as of this writing) back down to -0.64%, within sight of its own record lows.
What’s interesting about that trend in bunds (along with the same in schätzes and bobls) is that it has been near exactly mirrored by the exchange rate in the dollar, a plateau in US Treasury TIPS (American inflation expectations), interest rate swap spreads, and most of all global oil prices. Not strictly European doubts.
More interesting still, while practically every other market had turned deflationary (or, against the prior reflation direction) right at the end of August or in the first few days of September, the one which hadn’t was nominal US Treasury yields. These had been rising modestly.
This is not something you’d expect, anything other than the shortest run deviations between the US government market and its German counterpart. For years, the two have almost uniformly traded in near-lockstep fashion. Though at different levels, day-to-day changes on any given day along with the overall direction and behavior, these had been a pretty dependable constant throughout many years of these QE-follies.
Neither German nor American government bond investors have believed much in whatever either of their central banks have been selling (by buying assets). Certainly not to the point of an inflationary future both the ECB and the Fed have been, at times like these, absolutely desperate to paint.
There was, however, one multi-month period when, like the past few months, nominal UST yields rose while their German equivalent fell. It was the middle of 2018.
Insanely enough, most people might remember this period as the best economic boom of our lifetimes. The United States like Europe, each’s set of central bankers had claimed both had been thick in the throes of only the best of times.
In reality, as bonds traded, it was no such thing anywhere. Globally synchronized growth had already disappointed to the point that by January 2018 the global economy wasn’t synchronized any longer. Europe, particularly German, fell hard on its face right from 2018’s start.
Mario Draghi, the ECB’s top storyteller at the time, told the world not to worry about Europe. Still-ongoing QE in entering its fourth year would ensure this stumble was nothing more than a “transitory” one. The forecast for inflation and eventual acceleration remained undoubted, he said.
Though there was something annoyingly unsettling in the way he said it. From January 2018:
“The strong cyclical momentum, the ongoing reduction of economic slack and increasing capacity utilisation strengthen further our confidence that inflation will converge towards our inflation aim of below, but close to, 2%. At the same time, domestic price pressures remain muted overall and have yet to show convincing signs of a sustained upward trend.”
If you don’t speak central banker, I’ll translate: our models show inflation rising like we want and badly need, but right now there isn’t a single bit of evidence our models are correct.
The dollar had stopped falling against the euro (and a myriad of other currencies) right as Draghi spoke in January. Ominously, it then began to rise and in many cases quite sharply. Before long, the determined wreckage typical to rising dollar periods began to appear in more obvious ways that couldn’t be ignored no matter how hard officials made the media try.
Thus, German bunds stopped in their reflation tracks (February 2018) and easily, immediately reverted back to deflationary type. Economic growth in Germany, Europe, and a bunch of other places around the world halted, too.
Obviously, inflation was off the menu because it was never on the menu. Just in the models.
While that was going on in Europe (and across especially emerging market economies, sparking officials in some of them to plead, in the media, with Federal Reserve officials to at least pay attention to the rising dollar instead of their econometric models stuck like Europe’s on reflation then inflation which had already been thoroughly invalidated by the dollar’s rise), in America the word “decoupling” had reemerged just as it had at several points in the past. This didn’t quite mean what the term otherwise means to convey.
I wrote in September 2018 that you couldn’t ignore it any longer. Most did anyway:
“If the global money system tightens, the global economic system can do nothing about it. That doesn’t mean, however, that it registers everywhere at the same time. Decoupling is really just a misunderstanding of how that tightening is an irregular process, nothing ever goes in a straight line, a blindness to what are, in the end, differences only in timing and intensity.”
US Treasury yields were at the same time showing some resistance to Jay Powell’s forecasts. While nominal interest rates were rising throughout the middle of 2018 in contrast to those in Germany, the yield curve was being flattened out starting at the long end by Jay Powell’s rate hikes at the short end. In some curves, eurodollar futures, these were already inverted (June 2018).
Powell alone was trying to push up yields with his limited powers limited to the short end of the curve. The inverted eurodollar curve merely a signal that those limited powers were coming to a complete end – as they did within six months.
Even before the end of those six months, by October 2018, Treasuries had already re-coupled with bunds. Global yields were, in fact, uniformly declining long before Jay Powell realized he wasn’t going to be able to keep raising his policy benchmarks.
Despite years of promises, trillions of QE’s, statistical calculations, forecasts, publications, speeches, uniform reporting in all the financial media; there would be no inflation on either side of the Atlantic.
Perhaps of most interest, it was Alan Greenspan who actually gives to us the reasons why. Back in the nineties, the former Federal Reserve Chairman, the one they used to call the “maestro” for the same reasons they keep believing in these inflation forecasts, was struck by an important monetary phenomenon.
Some people like to live and die by the M’s and its partner variable V. In the equation of exchange, Irving Fisher’s, I guess, improvement upon Simon Newcomb’s equation of societary circulation, economic output or income and prices are determined by the money supply (M) and the velocity of money (V).
Thus, if you knew M and could piece together V, then you’d have some idea about output and inflation; specifically, changes in all four.
But you can’t piece together V because it’s not a real variable. Rather, it becomes a meaningless tautology, a plug line whereby it gets moved around by your estimate for M because M isn’t real, either. If M goes up, then V always goes down to match; QE’s push up the M’s, and V predictably falls while both national income and prices end up going nowhere.
Blame V if you want, but, as Greenspan was saying in 1999, before thinking about doing realize how we don’t even have a useful M.
“CHAIRMAN GREENSPAN. I must say that I have not changed my view that inflation is fundamentally a monetary phenomenon. But I am becoming far more skeptical that we can define a proxy that actually captures what money is, either in terms of transaction balances or those elements in the economic decisionmaking process which represent money. We are struggling here. I think we have to be careful not to assume by definition that M1, M2, or M3 or anything is money. They are all proxies for the underlying conceptual variable that we all employ in our generic evaluation of the impact of money on the economy. Now, what this suggests to me is that money is hiding itself very well.”
Hiding itself because it had moved off into the shadows decades before, only starting with eurodollar deposits and repo. More and more the financial products had proliferated (to paraphrase another, later Greenspan term) to the point by the eighties it had grown pointless.
Instead, these “monetary” policymakers had watched V go first up and then way down throughout the decade of the nineties without any explanation for it – other than how both up and down blatantly proved their definition of M couldn’t have been a useful one. The real economy, in other words, was using other forms of money which obviously weren’t included within any of the M’s – just as it had been starting in the sixties.
The problem hadn’t gotten better - the global financial system using other types of transactions to accomplish real activities – rather it had gotten out of hand. Great “Moderation”, sure.
Thus, if “inflation is fundamentally a monetary phenomenon” and you have no idea what the money supply (or demand) could even be at any moment in time, what are all these so-called authorities even talking about when it comes to either money, inflation, and, most of all, economy?
You’d think given all this that central bankers worldwide would have been studiously examining these shadows, picking them apart ruthlessly scrutinizing behind every corner in them, tearing things up until official understanding had everything down to the last detail. Down to the last offshore, virtual penny.
Alas, no. As noted last week, not even the BIS has made much effort – and the people there are among the tiniest few who even know they should try. The monetary shadows remain just as dark and unexamined today as back when Greenspan was misleading the world about what he actually did in his job (which was to purposefully mislead the world about the Fed not really being a central bank).
The BIS said it was “most opaque.”
“The complexity of global US dollar funding markets as well as certain data gaps prevent the construction of an accurate and complete map of activity. International banking data provide a view into the activities of internationally active banks, but they often lack information on maturity and counterparty type. Data for transactions occurring between non-banks (financial or non-financial), in particular those transactions occurring outside the United States, are among the most opaque.”
There are enormous consequences to this deliberate, self-imposed ignorance. As I wrote also back in February of 2018:
“The Fed says inflation is coming, though even they have been forced to admit fairly regularly (including their latest policy statement released this week) they don’t really know why. It is, at this point, more an article of faith in the mainstream than rational and reasoned analysis. The bond market is once more politely (for now) suggesting they take the time to figure out what they don’t know.”
Policymakers time and again always refuse the invitation for useful knowledge.
And that is why, by October of that crucial year, both German bunds and US Treasuries reconvened their Society of Money Printing and Recovery Non-believers after only a few months of temporary and partial “decoupling.” From the very beginning of 2019, globally synchronized growth had been totally converted into a globally synchronized downturn – US included. Rate cuts not hikes ended up being Jay Powell’s orders just as bonds like eurodollar futures had forecast.
Some forecasts actually do pan out; the ones we don’t want to have pan out.
So, what are we to make of bunds diverging from Treasuries since late August 2020?
Only, they aren’t denounced as evil when they bet in a way central bankers prefer. The amount of leveraged money specs short long bonds in the Treasury futures market has grown downright obscene. Not just record short, beyond anything ever seen before.
And they are betting everything on Jay Powell’s Fed – for reasons entirely to do with narrative and nothing whatsoever to do with actual money therefore inflation therefore real economic considerations. This is why, on the other side, the rest of the players in the futures market, the institutions of the bond market who actually do monetary things, everyone else is only too happy to pocket these speculative premiums.
For all these immense short positions, though Treasury yields have diverged they actually haven’t wandered all that much away. Closing in on half a million leveraged money spec net short contracts, 120k put on since late August, 220k since June, and nominal 30-year yields only got as high as 1.68%! Just 90 bps for the UST 10-year before violent short-covering forced on them this week the day after the election.
Motivated by the slogan interest rates have nowhere to go but up, it would stand to reason that as interest rates only go lower the probability and profitability of them finally going higher would be too immense to not bet on. And therein lies the apparently unrealized contradiction; told time and again interest rates can only move higher, yet they always end up lower.
Increasingly guaranteed profit potential, or time to rethink the whole narrative?
What that means in late 2020 is obvious, if off-putting to mainstream sensibilities that continue to view QE, bank reserves, and whatever else the Fed or ECB does as monetary policies. They are not monetary. Full stop. Despite rebounding as it has since May, the global economy is more and more looking like it did in the middle of 2018, hindered by dollar disease more than COVID.
The smallest silver lining, if you choose to see it, is that unlike 2018 this time central banks everywhere are being fully exposed. Lack of recovery, re-synchronizing the wrong way, and, despite trillions in more QE’s and such, not even the smallest hint that any of it was useful money printing. In 2018, people thought it might as well have been booming.
Central bankers don’t have the unearned luxury of such cover this time around. And while the leveraged specs bet on Jay’s narrative, everyone else in bunds and bonds are betting on the shadows. Again. They are the shadows.
Originally posted on Real Clear Markets