A Glaring Disconnect Or, The Most Important Thing You’ll Read All Day

To this day, one of the least appreciated dynamics in markets is the extent to which central bank liquidity is the proverbial rising tide that lifts all boats.

Sure, the Street gets it. And yeah, traders get it. But market participants in general do not appreciate to what they owe their post-crisis returns.

And that’s weird, because this is hardly a fucking secret. In fact, central bank go out of their way to shout about it every chance they get. That’s what “forward guidance” is.

Even among the “pros,” it’s not well understood that what matters isn’t the “stock” of central bank liquidity…

…but rather the “flow”…

And then there’s the EM FX reserve story. Remember, when EM liquidates their reserves – whether to support their currencies or for any other reason – that works at cross purposes with DM central bank QE. It is, as Deutsche Bank put it in the chaotic aftermath of China’s bungled August, 2015 RMB deval, “quantitative tightening,” or, “QT” for short. The main culprits behind “QT” are: China and Saudi Arabia, with the latter drawing down their reserves following Riyadh’s late 2014 decision to kill the petrodollar.

Simply put, QE is fighting against QT in an ongoing push to support risk assets and reflate the global economy. So to a certain extent, stories about how much DM central banks are doing in terms of accommodative policies are lacking if they don’t mention what EM is doing in terms of reserves.

Any assessment that fails to take into account all of the above, doesn’t tell the whole story.

Well, Deutsche Bank’s Dominic Konstam is out with his latest weekly missive and it’s a keeper, as it endeavors to capture everything said above on the way to pointing out a glaring disconnect. More below…

Via Deutsche Bank

More than ever before in this tightening cycle we would suggest that the Fed faces the most delicate of balancing acts. There seems to be an almost automatic convergence on a June tightening with September also a possibility and then some kind of balance sheet adjustment. The ECB is widely viewed to be not far behind in terms of another taper and the possibility of an eventual depo rate increase (we think 15 bps priced by August 2018) as a quid pro quo for QE extension, with the ultimate problem that few investors will buy Italian bonds absent the ECB at any rate level consistent with debt stability. Italy ultimately needs a growth miracle or a Europe deal. Japan seems still to be somewhat adrift of any central bank moves towards tightening but the implicit convexity of their ten year target means that if global rates rise, they will be required to lean against the wind to defend the target and vice versa. The significance of this cannot be underestimated in the context of the US 10 year term premium having almost the same sensitivity to BoJ purchases as the ECB and the Fed combined.

Global liquidity in dollar terms is not special. Having accelerated for four straight quarters from 2015q4 to a local peak of +5.0 percent in 20167q4, q1 saw the first slowing to a year over year growth rate of just 2.23 percent. In absolute terms it was $29.5 trillion, almost unchanged from 2016q3. The main culprit (again) was FX reserves that sharply dropped by almost 1 percent versus a year ago, based on February data. The weak patch for global liquidity growth is likely to extend through to 2017q4 where even based on flat FX reserves ahead of ECB or Fed balance sheet changes, the current rate of ex-Fed central bank liquidity growth should lift liquidity growth back to slightly over 5 percent year over year.

The problem is 5 percent is not a lot at a global level. It doesn’t accommodate faster nominal growth. And as the chart below indicates is consistent with relatively subdued bond yields. In 5y5y US Treasury terms a 3 percent rate seems a little elevated as is and is pretty much discounting liquidity growth closer to 10 percent, a level last seen in 2013. Global equities tell a similar story but even more starkly; they appear to be discounting liquidity growth over 10 percent. This is another example of how the equity market seems to be discounting something very different from the bond market.

There are a couple of ways in which these disconnects can be resolved. But until they are, global central banks need to tread warily. One resolution is of course equities retreat and yields decline, recognizing the dearth of liquidity. Recently we have used broader liquidity indicators in the context of nominal output for the US, Europe, China and OECD in general to demonstrate that there is falling “excess” liquidity that always implies some kind of loss in real output momentum with a lag. This doesn’t necessarily mean outright declines in output growth but it would, for example, be consistent with weaker PMIs and typically puts a ceiling of where longer term yields can rise to. Specifically we find that yield momentum tends to decline implying, specifically for the US that 10s might be capped around the 2 ½ percent level with downside potential closer to 2 percent on a moderate loss of upward yield momentum.

Another way we could see resolution would be an accelerated move higher in liquidity. This seems unlikely in terms of positive new accommodation by central banks, absent deterioration in observed growth or inflation. However it is possible if the dollar were to weaken which would reflate the dollar value of existing liquidity but also probably contribute to a faster recovery in FX reserves. The problem is that dollar rate correlation has remained stubbornly tight although as we have argued since Trump’s election, one senses that that correlation is less assured. Typically though a negative rate dollar correlation where higher rates imply a weaker dollar need to be a part of a rising inflation economic regime so that the dollar weakens as breakevens rise in order to attract funding; this is instead of the dollar rising because real rates are high that sucks in funding. One reason why we were so excited about the proposed border tax was that it might have contributed to such a correlation shift. At least this avenue now seems a non-starter.

Meanwhile the problem around falling excess liquidity is that since it partly reflects high pipeline inflation that has not been accommodated, not only does it contribute a loss of output momentum but it also makes the pipeline inflation less sustainable. The decline in commodity prices seems to be consistent with this. Recent weakness in the likes of iron ore, copper and oil are concerning. The weakness that we have seen in DXY, especially reflecting the European currencies, seems more to do with better growth expectations in Europe and relief around France politics. This will help global liquidity at the margin but Europe can ill afford a very strong euro and we think of this as more an idiosyncratic adjustment to the dollar rather than a US policy induced regime shift that sustains higher inflation.