Nedbank’s Neel Heyenke and Mehul Daya have been pounding the table on dollar liquidity for a quite a while now and their recent notes have gotten some attention for pointing out what looks like a rolling over in the world’s most important financial institutions.
2017 began with a consensus narrative about policy divergence predicated on the assumed quick implementation of Donald Trump’s growth-friendly economic agenda and a related assumption about Fed hawkishness in the face of late-cycle dynamics.
That narrative did not pan out and neither did the two consensus trades tied to it (“long USD” and “short USTs” were two of the most crowded trades in the world at the start of 2017).
Rate differentials (i.e., UST-bund spread), started to move in favor of the greenback again in Q4 of last year, but the dollar stubbornly refused to respond, in part because worries about the deteriorating U.S. fiscal position and the assumption that Trump’s trade stance amounts to a weak dollar policy by proxy undermined bullish sentiment around the greenback.
That all changed abruptly when a series of dynamics conspired to form a self-feeding loop. Those dynamics included the dollar funding squeeze precipitated by the knock-on effects of the tax cuts and the spending bill (e.g., repatriation effects and T-bill supply), the restoration of the dollar’s correlation with rate diffs and nominal 10Y yields and an unapologetic Fed that is pretty clearly determined to stay out ahead of things on the off chance the Phillips curve comes back from the dead as it’s wont to do. This was exacerbated by stretched USD short positioning (i.e., the move higher in the dollar was at least in part attributable to a short squeeze).
Well needless to say, all of that weighed heavily on emerging markets and the above-mentioned Neel Heyenke and Mehul Daya have argued that the dollar liquidity shortage that began to manifest itself in light of everything said above had the potential to become dangerous.
“Despite [the] reasonable arguments for a weaker US Dollar, we believe that the fundamental changes in global $- liquidity were overlooked,” they write, in their latest note, before reiterating that “today’s highly interconnected, heavily leveraged financial system, is still governed by the US Dollar.”
But their latest piece is a bit more optimistic. Specifically, they’re calling for “a ‘Tipping of the balances’ favouring a period of consolidation in the US Dollar, even though the current sentiment does not ‘feel’ like it.” Here’s more:
The US Dollar index has reached our target of 95 and we expect a correction or a period of consolidation (range 93-94) for several weeks to months, which should be supportive for risk-assets.
We need to point out to our readers that a number of our $-liquidity indicators are losing momentum to the downside, reaching important lows relative to history. This is clearly reflected in the panel 2. We believe that this is a subtle yet important indication to us the dollar shortage which has plagued financial markets in 1H18 and is losing momentum. Hence we believe that a period of calm is upon us.
So does that mean they’re bullish?
Well, no. Or at least not over the longer term. Here’s their stylized liquidity and credit cycle:
In explaining that visual, Heyenke and Daya write that if the dollar corrects, the “dial should remain between three o’clock and six o’clock in the cycle [but] when six o’clock strikes, it would be indicative that the next leg of US dollar strength has begun.”
That, they think, will transpire in the back half of the year. Their conclusion:
Although we are tactically bullish on risk assets in the short-term, relative to consensus, we remain bearish on risk assets premised on our view that the world will suffer from a shortage of USDs/relatively stronger USD.