Listen, Nedbank’s Neel Heyenke and Mehul Daya are going to make you people understand that this is all about dollar liquidity (or, more to the point, a lack thereof) if they have to figuratively kick down your office door and pull up the charts for you on your own terminal, ok?
When last we checked in on Neel and Mehul, the duo was busy providing what served as evidence of some of the points made by the RBI’s Urjit Patel in an Op-Ed for FT.
In that Op-Ed, Patel implored the Fed to consider calibrating the pace of balance sheet run-off to account for the increased Treasury supply necessitated by Donald Trump’s tax cuts. If the Fed fails to account for that, Patel argues, the Treasury supply deluge will soak up dollar liquidity at the expense of emerging markets.
Of course that strikes at the heart of the broader dollar liquidity narrative, which grabbed the spotlight in Q1 as dollar funding costs soared thanks in no small part to the knock-on effects of the tax cuts and the spending bill (e.g., repatriation effects and T-bill supply).
There are a number of self-feeding loops in place here, not the least of which is the interplay between the shifting supply/demand dynamics in the Treasury market, inflation and the greenback.
As the deluge of Treasury supply collides with Fed balance sheet runoff, the assumption is that the market will clear at lower prices (higher yields). Although the dollar’s correlation with 10Y yields looks like it might have broken down late last month when Treasurys rallied the most since Brexit amid the turmoil in Italian bonds, it’s reasonable to assume that with the policy divergence narrative back in play (i.e., hawkish Fed versus dovish ECB), the dollar’s correlation with rate differentials and 10Y U.S. yields should be restored. Meanwhile, the same late-cycle fiscal stimulus that necessitates the increased Treasury supply is prompting the hawkish lean from the Fed as that stimulus raises the specter of a sudden surge in inflation. The more hawkish the Fed, the higher real rates and the more support for the dollar. Again, there’s something hilariously self-referential (or maybe “self-defeating” is better) about the dynamics set in motion by the late-cycle fiscal stimulus push, and as detailed this morning, the tariffs only add to the confusion.
Needless to say, the dollar’s resurgence has led to an unwind of carry trades and is largely responsible for the recent EM malaise. If you want to cling to the idea that EM woes are primarily about idiosyncratic stories in Argentina and Turkey, then you’d be at pains to explain exactly what we know now about Indonesia and Brazil that we didn’t know three months ago, because it’s not entirely clear that you can account for the desperation inherent in BI’s hikes and BCB’s panicked interventions by reference to incoming information about rupiah fundamentals or election jitters in Brazil, respectively.
Whatever the case, this is where we are in EM FX on MSCI’s gauge:
I know one person who’s probably confused (I’m talking about Trump, not Lisa):
— Heisenberg Report (@heisenbergrpt) June 19, 2018
But circling back, two people who aren’t confused are Neel Heyenke and Mehul Daya, and in their latest note, they remind you that, quote, “the current sequence of events playing out globally and the resultant turmoil being experienced in the financial markets was not an exogenous shock, but was predictable.”
Yes, “predictable” because if you’re paying attention, it’s all about dollar liquidity. To wit, from Nedbank:
We believe the best way to understand the changes in global macro liquidity is through the lens of global $-Liquidity and the US Dollar. In a world where central banks control both the quantum of money (i.e. QE) and the price of money (policy rates) we must warn readers to keep an open mind to the changes in global macro liquidity as it is not just traditional monetary policy that matter —this has become very evident over the last three months.
The question for folks who aren’t inclined to look very far beneath the surface – which, unfortunately, is most investors – is when and how this spills over into equities. Well, Heyenke and Daya have some thoughts on that.
“The corporate curve is starting to invert which indicate the cost of capital for corporates is now higher than the return on capital,” they write, in the same note cited above, adding that “corporates are highly geared and we are concerned the next phase of a contraction in global $-Liquidity and rising real rate (term premium) will infiltrate the stock market.”
Here’s where it starts to get really fun. As you’re undoubtedly aware, the fabled “synchronous global recovery” comes courtesy of credit creation. This is something Citi’s Matt King has been pounding the table on for years, most recently in a note dated June 1. Well, that’s a shaky foundation, and when financial conditions start to tighten in earnest, the question becomes how a world addicted to credit can cope.
[Side note: One thing you should keep in mind here is that financial conditions remained loose in 2017 thanks to dollar weakness and persistently low 10Y yields stateside – that’s obviously starting to reverse, which means that for the first time since the start of the hiking cycle, Fed tightening actually entails tightening.]
Now let’s bring Nedbank back in. Consider this:
A market weighted cap index of the FSB’s G-SIFI’s has decoupled from the S&P500 and the Nasdaq since the beginning of 2018 , losing 18% or $850bn of its market cap value. We do not believe this decoupling will be sustainable. Either the rest of the equities must come under pressure or the financial sector must rally. We have been sceptical of “global synchronized growth” narrative in the market. The recovery was credit fueled and with the financial conditions tightening beneath the surface the strains are being reflected in the performance of these financial institutions.
Uh Oh, Spaghetti O’s!
Clearly, SIFIs are sensitive to dollar funding and as Heyenke and Daya go on to warn, there’s a “correlation and causal relationship between [Nedbank’s] $-Liquidity indicator and the performance of the G-SIFI’s”:
There’s a ton more in the note that’s South Africa-centric, but the overarching point is that some folks seem to be underestimating the possible knock-on effects of the burgeoning dollar liquidity squeeze.
Take that for what it’s worth, but don’t say nobody gave you a heads up.
It seems to me that a deficit-funded tax cut for America’s wealthy should have roughly 0 impact on growth or dollar liquidity (in the short term). The government returns money to wealthy taxpayers (relative to the previous baseline), and because those taxpayers are wealthy, they save the money. By…buying the additional debt issued by the government to fund the tax cuts. All that’s happening is assets are created on the balance sheets of wealthy households while liabilities are created on the government’s balance sheet. Now, obviously I’m ignoring cross-border flows and making assumptions about where tax savers will put their money, but I think once you walk through the ramifications of what happens once those assumptions are changed, the net result is essentially the same. Thoughts?
Of course, the long-run effects are negative as the government has to issue additional debt to support interest payments.
Time cash out of the market, buy some US treasuries at a discount, and then wait for another blowup-cum-QE event from the Fed to reinvest at another all-time market low!
Inflation is coming my ass