Dollar liquidity (or a prospective lack thereof) is an important theme in 2018 as the Fed proceeds apace with gradual rate hikes and the policy divergence between the U.S. and the rest of the world widens in favor of the greenback.
One of the more interesting dynamics in the back half of 2017 and for the first couple of months in the new year, was the extent to which the dollar stubbornly refused to respond to a USD-bullish trend in the UST-bund spread. Dollar weakness was generally attributed to two things: the idea that U.S. trade policy telegraphed the Trump administration’s desire for a weaker currency and worries about a deterioration in the U.S. fiscal position. Finally, starting in late April, the greenback began to climb with a continued widening in the spread between U.S. and German yields.
The first quarter of 2018 was defined by a technical dollar funding squeeze and a liquidity drain catalyzed by three key drivers (this is Goldman’s list, but there’s a general consensus on this across markets):
- The change to the tax treatment of foreign earnings from US companies;
- Changes to the Base Erosion and Anti-Abuse tax (i.e., BEAT);
- The surge in T-bill issuance.
The irony there is that all of that is tied to Trump’s fiscal policies which are themselves prompting the Fed to lean more hawkish than they otherwise might out of respect for the possibility that piling fiscal stimulus atop a late-cycle economy increases the chances of overheating. In other words, you don’t have to be a Trump detractor to know that in the near-term, his policies have led directly to a stronger dollar (much to his chagrin) and contributed to the Q1 dollar funding squeeze. [As an aside, those policies are introducing myriad longer-term tail risks, not the least of which is this: when the next downturn finally materializes, any Fed rate cuts will come against a backdrop of a deteriorating U.S. fiscal position, raising questions about who’s going to be willing to sponsor the U.S. long end and setting the stage for a crisis of confidence in the dollar].
This is part and parcel of what I’ve variously described as Trump’s dollar “insanity loop.” His fiscal policies and his trade policies are conducive to a steepening of the Phillips curve, and the Fed is cognizant of the possibility that reports of the model’s demise may be exaggerated (see: “Cheshire Cat’s Smile: ‘What Is The Fed Worried About?’”). The more Trump mashes the gas on the economy, the more worried (read: hawkish) the Fed gets. That, in turn, leads to a still stronger dollar which itself makes it easier for America’s trade partners to weather the tariff storm (i.e., the policy divergence puts depreciation pressure on the yuan, the euro, etc.).
That infuriates Trump and unless he decides to pull an Erdogan and actually commandeer the central bank on the way to engineering a weaker dollar, his “solution” to the “problem” is to simply lean even more protectionist. But to quote Barclays (from a note out earlier this year), “a reversal of trade integration/openness trends implies a steeper Phillips curve, increased sensitivity to domestic economic conditions, higher inflation outcomes in the long term (all else equal) and higher inflation volatility.” In other words: more reasons for the Fed to lean hawkish which exacerbates dollar strength. Again, it’s an insanity loop.
In addition to the tail risks inherent in irresponsible fiscal policy, the dynamics described above are potentially dangerous for emerging markets. Earlier this year, the RBI’s Urjit Patel wrote an Op-Ed for FT in which he implored the Fed to calibrate its balance sheet rundown to account for the increased Treasury supply that’s part and parcel of Trump’s fiscal stimulus push. Here’s the key excerpt from that Op-Ed:
[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.
Well, Nedbank’s Neel Heyenke and Mehul Daya have been pounding the table on dollar liquidity for as long as I can remember and they’re out with a sweeping new piece that’s worth your consideration.
They kick things off with the following chart, which plots the VIX against the relative preponderance of “dollar liquidity” news stories:
“Astonishingly for us, there is a high correlation with causality in our opinion between every financial market cycle (VIX) and with the story count in which the term ‘DOLLAR LIQUIDITY’ appears”, they write, adding that “this is another example of how the availability of US Dollars has a profound effect on financial markets.” Obviously that’s anecdotal, but that’s a pretty interesting chart, nevertheless.
Heyenke and Daya go on to note that while the following indelible image is generally seen as emblematic of the shifting geopolitical sands (read: deglobalization and the demise of multilateralism), it has profound market implications as well.
(A handout photograph from the German government shows a group of leaders at the Group of Seven summit, including German Chancellor Angela Merkel and President Trump, in Canada on June 9, 2018)
A consequence of globalisation was disinflation which allowed central banks to cut policy rates (discount factors). This helped stimulate economic growth and fuel asset prices. The destructive inflationary episode of the 1970’s meant monetary policy became focussed on consumer inflation targeting.
This caused investors to became obsessed with the monetary policy cycle. The market did not appear to pay attention to the extraordinary growth in the USD monetary base instead focussing on measuring the price of money (CPI) and not the quantum. This is still the case today. What resulted was all asset classes out-performed GDP as the rising tide of $-liquidity lifted all ships.
Next, Heyenke and Daya remind you that a contraction in the ratio of America’s trade balance to global trade has precipitated a number of busts. “The 2007/8 GFC stands out because the contraction in $-Liquidity was so severe, the Fed had to get involved to add USD M0 as the falling velocity of money and collateral kept spiraling lower, creating a negative feedback loop between financial markets and the real economy,” the Nedbank strategists write, before warning that “this ratio is now losing momentum again and if the US trade deficit shrinks because of Trump’s protectionist policies, USD creation will be a major problem.”
The implication here (in case it’s not yet clear enough), is that while U.S. protectionism may well be inflationary in the near-term, the longer-term consequences may be deflationary (remember: it was just last month when concerns about demand destruction sent the Bloomberg commodities index tumbling by the most since 2014).
Meanwhile, the world’s exposure to USD debt in this environment is worrisome. Here’s Nedbank again:
Should global growth become less synchronized the US deficit will shrink. This will provide less USD into the global financial system resulting in a shortage of dollars. Tighter monetary policy from the Fed, a higher Fed funds rate and shrinking of the Fed’s balance sheet, will further slow down USD creation.
The shrinking dollar monetary base will slow down the credit creation process because the economy is so highly geared. This shrinking pool of dollars will cause the dollar to rise. The strengthening USD means higher offshore USD funding and this will hurt USD indebted nations/corporations.
Moving right along, Heyenke and Daya note the extent to which new methods of financial market intermediation have served to supercharge the debt/credit creation process. As you’re undoubtedly aware, boring old fractional reserve banking is passé in the modern world. The following pyramid shows the levels of intermediation and how they’ve evolved since the crisis (i.e., shrinkage in the shadow banking components but ballooning in regulated sectors).
Obviously, “innovations” in the debt/credit creation process have led directly to asset price inflation outrunning measures of real economic activity. The juxtaposition between the two has been the subject of vociferous debate in the QE era, but it predates the crisis. The rolling back of QE represents a change to the bottom of the pyramid (and the pyramid is inverted, so the “bottom” is really the “top”) while regulators have of course squeezed the shadow conduits in an effort to prevent the type of leveraged insanity that preceded the crash.
“As the US trade deficit fueled the global monetary base from 4 to 16% of global GDP, and the process of Financialization began – the gap between the real economy and financial markets accelerated from the late 1980’s accelerating up out of an 80-year old band”, Nedbank writes.
“The global real economy cannot afford a shrinking base of the money pyramid” the bank’s strategists continue, before warning that “the indebted balance sheets of the world also cannot afford the asset deflation that will go hand in hand with shrinking money supply.”
Heyenke and Daya then present a series of dollar liquidity indicators, but in the interest of brevity, the bottom line is this (from the same note):
A slowdown in global growth, the US trade deficit not growing and the Fed continuing with its path towards tighter monetary policy will not bode well for USD creation. Because of this we believe the downside risks to financial markets will remain and intensify.
Oh, and if you’re looking for a specific level on the dollar index to watch, they’ve got one for you: it’s 95. A confirmed break above that, they contend, would “mark the beginning of the next risk-off phase.”
For our part, we’re not much for specific levels, but what Nedbank says after flagging 95 is very much in line with our thinking:
More importantly, it is not the value of the US Dollar Index per se that matters, but rather what it represents – i.e. expansion/contraction in the pool of money.
No further comment.