Urjit Patel And The Dollar Liquidity Shortage Debate

Listen, the RBI’s Urjit Patel is concerned about dollar liquidity, but really, he’s concerned that the Fed didn’t adequately account for Trump’s lunatic plunge into late-cycle fiscal stimulus.

Patel wrote an Op-Ed for FT on Sunday which is getting a fair amount of play hopefully because of who wrote it and not because of what it says, because anyone who has been following along over the past eight months could have written it themselves in the space of about 15 minutes.

That’s not to disparage the piece – not at all. In fact, it’s to do exactly the opposite.

That is, it’s just to say that what he writes is so obviously important and the dynamics he describes so self-evidently perilous, that one certainly imagines he was somewhat surprised that he needed to spell it out for folks.

If you really wanted to, you could try and cram his assessment into a narrative about intermittent dollar liquidity shortages and that’s useful to a point, but the overarching message isn’t complicated: the Fed’s balance sheet rundown is colliding with the deluge of Treasury supply Mnuchin unleashed to fund Trump’s tax cuts and that setup is going to end up choking off dollar funding. To wit:

Dollar funding of emerging market economies has been in turmoil for months now. Unlike previous turbulence, this episode cannot be attributed to the US Federal Reserve’s moves on interest rates, which have been rising steadily since December 2016 in a calibrated manner.

The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts. Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet. If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.

You’re reminded that the rise in dollar funding costs in Q1 was the direct result of increased Treasury supply associated with the Trump administration’s ill-conceived foray into late-cycle fiscal stimulus. The knock-on effects of the tax cuts and the spending bill (e.g., repatriation effects and T-bill supply) conspired to help push up funding costs and all of that comes as the Fed is attempting to wind down the balance sheet.

This is always the same story: the Fed hadn’t planned on Trump’s late-cycle stimulus push and it’s complicating their decision calculus by making balance sheet rundown more risky than it already was and by increasing the chances that nascent inflation pressures morph into something more dangerous and prompt aggressive hiking. Here’s Patel again:

When the Fed announced the normalisation of its balance sheet, the full extent and details of the Trump tax cuts were not known. Both scale and timing of the US fiscal deficit have been a surprise to markets.

[Previously] the Fed carefully adjusted the pace [of hikes] to evolving macroeconomic conditions. Global spillovers did not manifest themselves until October of last year. But they have been playing out vividly since the Fed started shrinking its balance sheet. This is because the Fed has not adjusted to, or even explicitly recognised, the previously unexpected rise in US government debt issuance. It must now do so.

In the full Op-Ed, he details the extent to which the Fed was able, for years, to foster and maintain the two-way communication loop with markets via forward guidance. Maintenance of that loop is a delicate thing and exogenous shocks have the potential to upset it.

In any event, the overarching point is that the Fed needs to adjust the pace of balance sheet rundown in order to prevent a situation where the market’s burden vis-à-vis absorbing new Treasury supply doesn’t end up soaking up all the dollar liquidity.

“A rough rule of thumb would be to reduce the pace of its balance-sheet contraction by enough to damp significantly, if not fully offset, the shortage of dollar liquidity caused by higher US government borrowing,” Patel writes.

Clearly his paramount concern is what the knock on effects will be for emerging markets. We’ve been over this before, but rising U.S. yields and rising inflation expectations have created a self-feeding loop that’s helped drive the dollar higher this year as real rates have become, to a certain extent, a function of inflation expectations (i.e., the prospect that fiscal stimulus will ignite inflation makes the market hyper-sensitive to nascent evidence of price pressures as traders try and view that evidence through the lens of the Fed’s reaction function). The surge in the dollar has been exacerbated by a squeeze of the spec USD short, leading to a scenario where, there for about three weeks, it looked like emerging markets might unravel in dramatic fashion. If you’re super interested in this, see these posts:

So at this juncture you’re probably asking yourself the following: “Is this fucking moron really going to subject me to ~900 words worth of Heisenberg’s editorializing around someone else’s editorial without even showing me any charts??”

Yes. Or actually no. I was going to do that, but mercifully for you, I found something new from Nedbank’s Neel Heyenke and Mehul Daya that dovetails nicely with this discussion.

“The ‘tide of liquidity’ that has supported global growth and financial markets since 2015 has peaked and is contributing to the shortage of dollars globally,” the duo writes, in a note dated Tuesday, before adding that “the impact of a slowdown in excess global dollar money supply and a stronger US Dollar has the tendency to expose weak balance sheets – this time will be no different.”

They go on to note that EM will obviously be on the front lines in the event global dollar liquidity continues to dry up.

Turkey, they write, “is potentially only one of the first dominos to fall.”

Will DM central banks be forced to step in? Yes, according to Nedbank, but the question, as ever, is “how much pain are they willing to tolerate before they add liquidity or cut rates?”

In many respects that’s the only question that matters. Below, find more color from Heyenke and Daya who explicitly echo the Op-Ed excerpted above. We’ll present it without further comment:

After the 2008/9 GFC as central banks reached the zero lower bound and could not stimulate the economy with monetary growth via the traditional monetary policies authorities began experimenting with changing the quantum of money through extraordinary monetary policies i.e. QE programmes. Hence the “plumbing of the USD financial system” become even more important. We monitor the changes in excess dollars in the US banking system very closely as there is a strong correlation between excess dollars and the euro-$. (also with other funding rates such as LIBOR and cross-currency basis). Excess dollars in the banking system means more velocity and liquidity which eases financial conditions leading to a risk-on environment, the opposite is true also. Financial markets are facing a “double whammy” as the Federal Reserve continues to taper its balance sheet. The record debt issuance by the US treasury is also competing with the global financial system (Eurodollar market) for dollars. The resultant dollar shortage is leading to a dollar rally, deviating from the traditional ‘interest rate parity’ theory.

Our Global $-Liquidity Indicator (GDL) where we measure the annual change in the dollar monetary base is also losing momentum which is contributing to a stronger dollar and tighter financial conditions. At this stage the rate of dollar liquidity growth has slowed down but is not negative year on year. Every time dollar liquidity contracted on a annualized basis it has exposed weak balance sheets and eventually led to strain in the financial system. Our Global $-Liquidity indicator is moving closer to negative territory and the cavalry (central banks) better get ready to reflate the system again.