For a country like Cayman whose currency is tied to the U.S. dollar and therefore to the whims of the U.S. Federal Reserve’s monetary policy actions, the Cayman Investment Summit had a decidedly gloomy message: the U.S. dollar-led global currency system is in urgent need of reform and central banks have essentially no power to affect monetary or economic goals.
The conference, hosted by the Chartered Financial Analyst’s Society of Cayman, is never shy on pessimism and often invites speakers whose theories run contrary to mainstream economics. But given the track record of mainstream economics, that can be of significant value for investors who have to anticipate the big and small swings in the markets and their underlying economic factors.
Most recently, U.S. central bankers seemed at a loss as to why there is no inflation.
While some blame sharp online retail price declines, to an extent that is still misunderstood by economist, for low inflation figures, others argue that central bankers have been unable to interpret money supply and other monetary indicators for quite some time.
In an article about a crisis of confidence for central bankers, The Financial Times wrote in October that “the ability of central banks to resolve these questions does not just affect growth rates, but is fundamental to the health of the democracies of advanced economies, many of which have been assailed by populist uprisings.”
Jeff Snider, head of Global Investment Research at Alhambra Investment Partners, agrees with these political and social implications, but he says that after the financial crisis “central bankers did not suddenly lose all their power, they did not have it to begin with.”
Snider identifies the Eurodollar market, U.S. dollar-denominated deposits, as well financial instruments and transactions in U.S. dollars outside of the United States, as one large element of the shadow banking markets that are outside of any monetary control.
“There is no other, more appropriate place on Earth to talk about money than here” in the Cayman Islands, where U.S. banks are holding more than $1 trillion in U.S. dollar-denominated claims on Cayman banks, he said at the conference on Oct. 11.
Snider’s theory is that economists who viewed each economy as a closed system failed to recognize the effect of Eurodollars. They first misunderstood the growth of the market as capital outflows and then as a global savings glut. Central bankers, on the other hand, recognized these markets but ignored their effect even though monetary supply trends veered increasingly off trend.
Shadow banking means a lot of things to different people. For Snider, it is the balance sheet capacity of private banks globally for Eurodollar instruments, repurchase agreements or repos, interest rate swaps and other financial instruments like FX derivatives.
In September, the Bank for International Settlements, which is sometimes called the central bank of central banks, published a study that estimates $13 trillion to $14 trillion exist in offshore interbank FX derivative dollars that “are functionally equivalent to borrowing and lending in the cash market.”
“It takes the form of whatever liability one bank can dream up that another bank will accept,” Snider says.
Crucially, much of this money is not captured by any monetary statistics which should guide central bankers in their actions and when they set monetary policy targets.
It is not that these developments had gone unnoticed by central bankers. Both Eurodollars and repo were once included in M3, the broadest money supply figure, but discontinued in March 2006 when the Federal Reserve decided it would take too much effort to determine what is going in these markets when for the most part they do not affect the United States.
Former Federal Reserve chairman Alan Greenspan warned for years that finding money and measuring it had become an increasingly dubious proposition.
“The proliferation of products has been so extraordinary that essentially a decision-based policy on measures of money presupposes that we can locate it,” he said in June 2000. Even during his famous “irrational exuberance” speech in 1996, a warning that the markets were overvalued several years ahead of the dot.com crash, he noted that “money supply trends veered off years ago as a useful summary of the overall economy.”
This is evidence, Snider contends, that central bankers have not acted as monetary stewards for a long time. As early as in the 1970s, central bankers suspected the Eurodollar market undermined money supply in some form. Guido Carli, an Italian central banker at the time, warned that there was a monetary blob lurking hidden in the shadows of global finance which multiplied U.S. liquid liabilities outside of any monetary control.
Repo transactions, for instance, were not believed to be monetary transactions. Today, economists understand that in the real economy they are used as a monetary equivalent. The proliferation of products that defy monetary classification and national boundaries has made monetary policy very difficult.
“Because of this, we are forced to reassess everything that happened during the period,” Snider says.
“The idea of a great moderation, a golden age if you will, of classic economic conditions in the ‘90s up until 2007 always seemed a bit off for what actually took place.”
The bank balance sheet capacity of Eurodollars may have been missing from official handbooks, he says, but it has been out there all this time “reshaping the global economy for decades.”
As such, it is a currency system without any currency and it is in urgent need of reform.
“When global money was growing, the global economy was too. No more growth in global money, no more global growth. It’s that simple,” Snider says.
“Now that the Eurodollar system is no longer functioning, the global economy is not fine. It is in fact heading in the wrong direction and the political and social order is slowly being taken down with it.
“The primary risks here are not necessarily economic, they are social and political,” he says. “The economic damage has been done.
“People realize there is something wrong here. They don’t know what it is and their leaders are telling them there is nothing wrong. If you listen to Ben Bernanke and Janet Yellen talk, it is as if the economy is fine and we know it’s not. Not the United States, it is all over the world, Europe, China. The problem is that the longer this continues, the more dissatisfaction will be there.”
Snider has little faith in the central bankers or the politicians, because there is very little consensus what is wrong and much less how to get it right.
A second Bretton Woods that stabilizes the global currency system would be a very positive outcome, Snider believes but he suspects that most reform only comes after a crisis.
Simon Mikhailovich, co-founder Tocqueville Bullion Reserve, agreed that current markets are heading for another crisis.
“Nobody knows when a crisis is going to happen. All we know is that it does not make sense. And when a situation does not make sense, it will eventually resolve itself. But we don’t know how and we don’t know when.”
Mikhailovich’s list of things that do not make sense in today’s market is long.
Real income growth over three decades compared with nominal growth is virtually zero, he notes.
Negative interest rates have never happened before in 5,000 years. “This [makes] no sense, it never did make sense and it makes no sense today.”
European BB-rated junk corporate bonds, he says, are now trading at a yield that lower rate than U.S. Treasuries. “Are they less risky than U.S. Treasuries or does it mean that we have a problem with the way prices are formed?”
Meanwhile, pension funds cannot fund themselves when only 20 percent of all fixed-income securities are yielding over 4.5 percent. The only solution is to increase leverage, but the problem is that asset prices are correlated with the rise of leverage and the rise of debt, which is growing faster than the economy. As a result, there is 40 percent more debt in the world since the financial crisis.
Derivatives are another market conundrum that Mikhailovich points out. Deutsche Bank has $47 trillion of derivatives on their books, three times the size of the European economy, he says. The banks, of course, claim the net exposure is zero as long as they can meet their obligations. Yet it takes only one bank not to be able to meet those obligations to throw the system into crisis.
For the past 35 years, Mikhailovich says, it has been a one-way ride as interest rates kept declining and the values of financial assets kept rising. Very few people working today have experienced a prolonged period of rising interest rates and the effect that has on prices, asset values and markets. “Nobody under 70 has ever seen a real bear market. We have no gut feel for any of this.” Most importantly, “we have lost the culture of preparedness,” Mikhailovich says.
“The key is not to predict the future but to prepare for it.”