Over the course of the last eight months, Nedbank’s Neels Heyneke and Mehul Daya have variously argued that a dollar liquidity crunch is on the horizon and, if it materializes as expected, will have potentially serious ramifications for a world accustomed to the post-crisis DM monetary policy regime.
A decade of accommodation by the Fed and other developed market central banks sent investors scurrying down the quality ladder and out the risk curve in search of yield, and that, in turn, distorted markets, incentivized the buildup of foreign currency debt by developing economies and generally destroyed price discovery as everything converged on one trade.
As Deutsche Bank’s Aleksandar Kocic put it back in January, “free choice has been eliminated and replaced with a free selection from among the options on offer.” Here’s a great passage from Kocic’s note:
Through their communication with the markets Central banks, and the Fed in particular, have become “good listeners” with their decisions and actions made with markets’ consent. After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really.
Now, that dynamic is reversing. DM central banks are attempting to normalize and as rates rise and balance sheets are unwound, investors are suddenly presented with real “choices” as opposed to simply a selection from a menu of options that all amount to an expression of the carry trade.
“TINA”, as it were, is dead. Suddenly, there is an alternative. For instance, there’s USD cash (short-dated USD fixed income).
That means the tide is going out and the first “naked swimmers” (to employ the adage) to be exposed are vulnerable EMs that rely heavily on external funding. Hence the pressure on, for instance, Turkey and Indonesia.
Early last month, the above-mentioned Neels Heyneke and Mehul Daya dedicated a lengthy note to this subject. In it, they also discussed the extent to which current U.S. trade policy could exacerbate the situation. You can read some highlights from that note in “Dollar Liquidity Dynamics: An Epochal Shift Is Coming, One Bank Warns.”
On Thursday, the Nedbank duo is back with a new piece that touches on the same subjects, but frames the discussion as a kind of crisis retrospective. More importantly, it comes with a penetrating look ahead that’s couched in terms of dollar liquidity dynamics and debt creation. They begin as follows:
Currently, there is a ‘celebration’ that a decade has passed and that the world has overcome the fallout from the crisis. Even though policy makers have averted the economic downturn in the immediate aftermath of the GFC from spiraling into a debt-deflation collapse last seen since the 1930s’ Great Depression, we do not believe the ‘coast is clear’ as many proclaim. The world remains vulnerable because of soaring debt levels, growing imbalances, protectionist policies and overvalued asset prices.
To illustrate the disconnect between debt-fueled asset price inflation and real economy outcomes, they employ a similar chart to one that Goldman has used time and again. Here’s the Nedbank version:
After going back over some of the points mentioned in the linked post above about the dollar’s role in the global economy, Heyneke and Daya return to the disconnect between asset prices and the real economy. To wit:
From 1900 to 1980, global stock markets as a ratio of global GDP fluctuated from 25% to 60%, never exceeding 100%. In other words, the global stock market cap never surpassed global GDP. All that changed in the 1990s. The 1990s, when deregulation policies of the financial sector started to be implemented on Wall Street ( Clinton-Rubin era) was the beginning of ‘financialisation’. Deregulation and the process of ‘financialisation’ made virtually any commodity or asset tradable, with the intention of hedging risks for market participants. However, this also allowed excessive gearing to take place in financial markets and, as a result, financial assets began to exceed the economy, ushering in a more volatile and vulnerable financial system. Most of the money today is being created against collateral (assets) and, coupled with rising assets prices, fuel further leverage in the system. Unfortunately, when asset prices fall, credit creation slows rapidly, creating a liquidity squeeze in the financial system and the real economy. This has been the case for decades, but the build-up and crash in 2008/2009 was the most damaging to the global economy.
Obviously, asset prices as a driver of the economy is an example of putting the cart before the horse. It is, to quote Nedbank, “the tail wagging the dog.”
The result of this perverse dynamic is that “every downturn starts in the financial markets (credit cycle) because of excess leverage spilling over into the real economy”, Heyneke and Daya go on to write, adding that in their mind, next time will be worse due to growing societal imbalances.
“We believe the next downturn will be worse from a socioeconomic perspective because policies since the GFC have led to the wealth effect being concentrated in the top 90%, with the rest of society still overburdened with balance sheet problems”, they note.
That echoes the sentiments of other analysts who have weighed in recently on what the next crisis might look like. There is little question that the post-crisis monetary policy regime served to exacerbate inequality. The policies were designed to inflate the value of the assets that are concentrated in the hands of the wealthy. The assumption was that would create the fabled “wealth effect”, and while you can argue that it has, it’s difficult to argue that it’s worked as intended. The first chart shown above clearly suggests that policymakers overestimated the efficiency of the transmission mechanism between asset prices and the real economy while underestimating the efficiency of the transmission mechanism between their policies and asset prices.
The bottom line, from Nedbank’s perspective, is that far from being out of the proverbial woods, we might be just entering the dark forest. Here are some stats they throw out on global debt (these echo the discussion from their previous work in which they used a pyramid to detail the levels of financial market intermediation and how those levels have evolved since the crisis – i.e., shrinkage in the shadow banking components but ballooning in regulated sectors).
Global debt levels continue to grow to alarmingly high levels in both the regulated and unregulated sectors (shadow-banking activities). Global debt (regulated) has now soared to USD247tn (318% GDP), more than USD96tn higher than a decade ago. The shadow-banking system has grown from USD60tn in 2007 to the current USD99tn, according to the global FSB. Dollar-denominated debt issued by non-US countries has ballooned from USD10tn to USD34tn since the GFC. In the current environment of increasing US dollar scarcity, we believe this debt is very vulnerable to changes in Global $-Liquidity – this was evident during 2018. Excessive debt levels and highly interconnected financial markets leave world economic growth and financial markets vulnerable to a sudden slowdown in credit creation and debt growth – the vicious credit cycle that feeds into the real economy.
In case it isn’t clear enough from that except, dollar liquidity is at the heart of it all and it is rolling over according to Nedbank’s indicator…