Guest Post: On Currency Swaps And Why Gartman May Be Wrong In Focusing On The Adjusted Monetary Base

Tyler Durden's picture

Submitted by Martin Sibileau from A View From The Trenches

On Currency Swaps And Why Gartman May Be Wrong In Focusing On The Adjusted Monetary Base

Today, we were supposed to follow up on our last topic (how to shift to a commodity-based standard, with a 100% reserve requirement). However, we will have to leave that for quieter times. Right now, we have to address a few points that we have been making since 2009:

There’s a truly “must-read” book, for anyone who is really interested in understanding how central banks have run the show since the 1920’s: “The monetary sin of the West”, by Jacques Rueff. In his memoirs, M. Rueff makes it clear that the rally that ended in October 1929 was fueled by what we call today currency swaps. Indeed, in 1931 (Robert Triffin was still a student) M. Rueff was writing:

“…There is one innovation which has materially contributed to the difficulties that are besetting the world…(…)… Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange. The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin. The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect. For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market, without reducing in any way the money supply in their market of origin. The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit.” Letter to Pierre-Étienne Flandin, October 1st, 1931.

The innovation M. Rueff referred to 81 years ago was what Keynesian economists of the 21st century very mistakenly call “decoupling”; a term that was used precisely to characterize the impact that the reduction in the price (to 50bps) of USD currency swaps had on the funding market, in December of last year. Today, this impact is best reflected in the cost of funding of the world’s carry currency, the US dollar, in terms of Euros. That price is called the Eurodollar swap basis. From the chart below (3-month basis, source: Bloomberg), we see how it has performed since 2008, as a result of interventions. Every time the cost spiraled up (basis down), the Fed intervened with the swaps (i.e. US dollar liquidity lines).

On December 12th, 2011, we explained the mechanics of these swaps, and in January 2012, tired of reading the idiotic claim that policy makers had decoupled the US from the Euro zone, we wrote in a note titled “There is no decoupling” that : “…The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps …”

Why did we say (and still maintain) that “The problems of the Euro zone are now really coupled to the Fed’s balance sheet”? The same economists who view these swaps as decoupling the Euro zone from the USD zone also believe that the swaps effectively removed “tail risk”. As we warned on March 4th, the FX swaps would allow credit Euro zone corporations to raise debt in US dollars, opening the door for the European Central Bank to monetize sovereign debt and crowd out, in Euros, the non-financial private sector. In US dollars, this crowding out was not going to happen (and it did not happen), courtesy of the Fed.

However, if the Euro zone was going to survive, we wrote that: “…eventually, we shall see a wave of EU corporations defaulting: Compared to US corporations, EU companies are exposed to higher taxes, an overvalued currency, institutional uncertainty and the benchmark rate ( i.e. sovereign spreads) is higher than that for US companies (i.e. US Treasuries)…. but, if that wave of defaults occurred…who would be bailing out the US institutions that financed the EU corporations? Yes, you guessed right: The Fed! No, Bernanke did not mention QE3 last Wednesday, but we don’t need him printing monetary base to create the next bubble. All we need is a good currency swap, cheap Euro rates, a zombie EU financial system and the commitment to keep USD real rates in negative territory until at least 2014.” We offered the chart below:

Which brings us back to the core of today’s article…What has happened since we wrote about these issues?

First, last week Dennis Gartman, in his homonymous letter said that he was concerned about the fact that the adjusted monetary base has been falling, rather than rising, taking away the bullish case for gold on the topic of “money printing”. One must therefore remind those with this concern that the credit expansion caused by the backstop of the Fed alone is enough to inflate asset prices. This is consistent with the case we made in our last letter, that a commodity based standard is not as relevant as having a 100% reserve requirement. By the same token, if the reserve requirement is below 100%, it is not that relevant to see the expansion of the monetary base! The “printing of money” will eventually come, when EU corporations begin to default and the Fed has to “ensure there is enough US dollar liquidity”. It happened in 1931-33, in spite of the fact that the adjusted monetary base had been contracting since 1929: The US dollar was devalued from approx. $20.65/oz to approx. $34.70oz and gold was confiscated. If you don’t believe this, here’s the video showing the bailout of Germany from USD debt, announced by President  Hoover in 1931:

And here’s the announcement of the confiscation of gold:

It can happen in the future, because the same Ponzi scheme is being played out before our eyes. We are not alone with this concern. Congressman Ron Paul has publicly expressed this view, as this video shows:


But, how do we know this is a problem? Is it true that EU corporations have already embarked in US dollar borrowing which can have consequences in the future? On October 5th, BNP Paribas’ US Credit team published a review of the state of the Yankee market. Compared to a decade ago, the Yankee market represents now 20% of the US dollar corporate bond market (from 10%), but the strongest growth occurred since 2011/12. The same publication notes that industrials (i.e. non-financial issuers) have grown in importance and now constitute 58% of all Yankees (bonds) (Curiously, the authors of the publication see this positively, because –apparently-, thanks to this growth in US dollar borrowing by non-US issuers, the market (both demand and supply) gains in diversification. I hope someone reminds these people to check what level the cross-asset correlation reaches, when the next liquidity crunch comes. Our bet is that it probably reaches 1!)

 Can we see this “coupling” of the Fed’s balance sheet with the rest of the world causing other distortions? The Credit Derivatives team of Morgan Stanley, in its Credit Derivatives Insights publication of October 9th, noticed that less than 5% of the bonds in USD non-financials (in the iBoxx) are trading below par. And in the high-yield space, 70% of the non-financials are above par. What’s even worse, 24% of high-yield non-financials is even above their call prices!

In this context, hedging with credit default swaps is not efficient, because under the respective contracts, protection on default is covered only up to 100% of the price of the bond, and these bonds are trading above 100%. This means that, in some cases, even if one bought a bond and hedged it with a credit default swap, at default, one would suffer a significant loss. In other words, this shows a probability of default that is under priced, underestimated. And guess what…it makes sense!! Yes, with Bernanke at the helm of the Fed, you have to underestimate the probability of default, because he is telling in our faces that he will print dollars as long as US dollar liquidity is needed! But, but….should we really fear defaults? Well, there is always the ongoing concern that the Euro zone may break, sending shock waves everywhere. But also, in corporations, leverage is once again building up, and this time, more because EBITDA is deteriorating than the debt increasing.

This brings us to our final point: Will interest rates increase? We have observed a discrepancy of views in US Treasury rates forecasts this week too. If you read our last letters, you will know by now that we expect, if the ECB engages in its Outright Monetary Transactions, a convergence of short-term sovereign yields within the Euro zone. And, in the end, we expect both the short-term Euro zone yield and the USD yield to converge too, courtesy of the Fed’s coupling via the backstop entailed in the FX swaps. But the path towards that convergence is what has been taking our attention lately. We think that in the beginning, US yields should increase until a maximum tolerable level is achieved, after which, the Fed intervenes via purchases to keep yields within an implicit target. Until we get there, we will have to first see the bailout of Spain and some concrete steps towards an EU banking union. That will surely be the topic of future articles. But right now, obviously, we’re not seeing the materialization of these steps.

Once that level in USD rates is reached, the Fed will have to regularly purchase US Treasuries, to keep yields within their acceptable range. The assumption is that both the US fiscal deficit and the Outright Monetary Transactions continue. This would devalue the USD, making Yankee issuance even more palatable! This will be the bailout of the Fed, to the EU corporate sector and it can only last as long as the appreciation of the Euro does not hurt the Euro zone periphery. But it will…

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Squid Vicious's picture

I shall be short of Gartman

Bay of Pigs's picture

Dennis Gartman understands very little about the gold market. In fact, he's a stooge blinded by his own arrogance and buffoonery.

Quinvarius's picture

Gartman is always wrong.  It is the first rule of the markets.  Gartman is always wrong.

Spitzer's picture


Dennis Gartman.....

Hey Dennis, how much money was printed to have gold rise by 50% priced in Icelandic Krone or Thai baht in 1997 ?


Martin T's picture

I agree with Martin, namely that in the credit space the positive basis wit mos bonds trading above par is a cause for concern. Troubles are brewing and like Bastiat rightly said, there is always what you see and what you don't see...

buzlightening's picture

Gold has always been the worlds reserve currency.  Smoke & mirrors of banksters with paper fiat substitutes as money, are always printed into worthlessness by governments.  Ours will be no different and the USDinker dollar is racing to zero against gold as all other fiat currencys.  The dumbest person on the planet will soon know paper fiat monies get printed into worthlessness.  What won't be known is that there's not enough real money  gold/silver for every person on the planet.  Many get stuck with worthless paper.  History repeats, rhymes, or cheats innocent people out of their wealth by greedy corrupt governments.  If you didn't know this yesterday, your wealth is being transferred to corrupt hands.  Same ponzi just different people involved. 

Yen Cross's picture

  Gartman "silently" jumped on the Z/H(pm), bandwagon months ago, when he hit that eur/xau short trade! I would love to see a heated debate between, Schiff and Gartman!

ebworthen's picture


They have and can debase the currency and confiscate gold.

It is clear that the FED is defending the banks, corporations, foreign economies, and the fiat currency.

Employment and Inflation are not even on their radar - words they throw about as they do taxpayer money and savings.

socalbeach's picture

That's why he should be called Ben Banknanke, or perhaps Banknanke Ben.

QQQBall's picture

Foreign economies? You mean Euro banking system.

knukles's picture

The operative consideration is to what the Adjusted Monetary Base is being applied by the banking system.

In ordinary times the system is usually operating at a level somewhere close to the capacity of the Reserve Base so to speak.  As Reserves increase or decrease there is a general concomitant reflection in the outstanding bank loan balance ....  Oversimplified but nonetheless reasonable for this purpose.

In today's environment, that of a Liquidity Trap, Reserves are not being applied to loans but to temporary types of investments.... bonds, deposits at the FED, etc.  As such, any leveling off or even contraction of the Base is absorbed within the FED deposit or other investment categories and as such does not impact outstanding Loans for which there is No Demand.

Under such conditions, the Monetary Base can contract and resultant deposit/loan activities which are not impacted have no resultant impact on economic activity, just as the QE's have had none on the upside.


At this time, not a worry....
However, once Velocity rebounds with excess reserves in the system.... Gonna be a big problem.  And in the mean time, the impact of excess monetary expansion not translated into Real GDP is on the general level of prices (Inflation) for the portion of the monetary growth not absorbed by declines in Velocity.

It's all the effect of a liquidity Trap caused by a Credibility Trap... which is behavioral.  Meaning that meaningful economic activity will not increase until some reasonable change in the DC/banking/legislative/lawlessness environment is addressed... good luck and don't hold your breath.

Just Ice's picture

Simplification's always good.


Popped credit bubble causing macro debt deflation together with lack of velocity of funds -- the reserves in essence being used as emergency savings, to fall back on for funding operations if need be, or, like other corporates with a lot of cash sitting in their accounts, being used by healthy institutions as savings held aside for future investment whenever a deal arrives thanks to some other entity's failure / fire sale -- appear to be overwhelming / counteracting the printing press of the Bernank. 

I've been looking for some time for the 30-yr bond futures to make a run at 160 before treasuries top out, (followed by a 2-3 year topping range, my guess, since a blow off top would be extremely low odds following a 30+ year bodacious bull market).  I thus did not agree with most of the author's conclusions in this article, 'though good article.

max2205's picture

Money markets are full of Yankee bonds and will self destruct when the euro zone implodes. 13 trillion at risk.

Should be a mess

malek's picture

Wow, just wow!
Reading ZH for 2.5 years now, but this just wants me to award a 6 star rating.

So by letting others malinvest dollars, the Fed is able to change it's role from fraudster to savior, when the next unavoidable crisis hits!

In more detail:
So by [freely and willingly, unbeknownst be the vast majority] letting others malinvest dollars on a massive scale, the Fed is able to change it's role from fraudster [for creating money from thin air to bail out guilty US parties] to savior [for creating money from thin air to bail out guilty foreign parties], when the next unavoidable crisis [made unavoidable in large part by those Fed actions] hits.

WhiteNight123129's picture

Well both are wrong.

As you probably know a conventional money/ irreedemable compulsory issue or fiat more simply acquires its value in use. Given the US is about 20% of world GDP but 60% of foreign central bank reserves, if the US were to cut swaps, Europe would be forced to find an alternative, could it be to make their Gold reserves (large than the US) enter the monetary system?

The issue of teh Euro overvalued in the context of funding of the US dollar through reserves excessive in relation to the size of hte US economy is a bit of a joke. You will find 0% PRC bonds in foreign central banks.

Internationalization of the Yuan (which is happening) is a declaration of war on the funding source of teh US. When China trades with BRazil in its own money, it refuses to pay its due to the overlord (US), when Malaysia and Brazil would use Yuan, China would compete against the US on collecting seigniorage.

So why on earth would the US decide to voluntary cut SWAPs? To raise the cost of funding of the US by starting a cascading chain of search for alternatives to teh dollar by the Europeans.... Makes no sense whatsoever.

As for Gartmann, maybe he is right, but then the cost of borrowing from teh US would rise inevitably if the Fed stops printing, and we are supposed to enter something very close to a recession again according to the IMF, does it make sense to reduce the issues when entering a recession?

Ask the Bank of England in 1819 and check what was teh result on prices (down 15-25%). Gartman is funny, like the FEd is going to go for a contraction voluntarily just as we enter another rough patch... bwahahaha...


Lore's picture



"Until we get there, we will have to first see the bailout of Spain and some concrete steps towards an EU banking union."

This guy is saying that pumping blood into zombies is a good thing, because it leads to more blood being pumped into bigger zombies, and the best thing would be to stitch all the zombies together in order to make a SUPER-zombie. WRONG. WRONG. WRONG. WRONG.  ALL OF THIS COULD HAVE BEEN AVOIDED IF THE CONTROL FREAKS LEFT EUROPEAN COUNTRIES ALONE.  When the next big war is done, and people look back on reasons why, I hope some of the financial terrorists find themselves before a Nuremberg-style tribunal.