This isn’t all that complicated.
When you inexplicably decide to pile deficit-funded stimulus atop a late-cycle dynamic at a time when the Fed is pulling its support for the same debt market you’re tapping to fund the stimulus, you’re likely to end up creating a USD funding squeeze.
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.
When you throw in the fact that piling stimulus atop a late-stage expansion is inflationary and then you go ahead and exacerbate that situation by slapping tariffs on hundreds of billions worth of imports, you tempt fate, prompting the Fed to lean more hawkish than they otherwise might in the interest of staying out ahead of a prospective overheat.
The end result: What Jeff Gundlach has variously described as a “suicide mission“.
“It’s pretty much unprecedented that we’re seeing this level debt expansion so late in an economic cycle,” Jeff mused, in a June webcast, adding that “increasing the size of the deficit while we’re raising interest rates almost seems like a suicide mission.”
In case you need a visual refresher, this is how anomalous the current state of affairs is:
Jerome Powell appears to be reinforcing the notion that the Fed is intent on hiking until something breaks. The FOMC is restriking the Fed put and the September minutes underscore the notion that there’s support on the committee for creating restrictive policy. Eventually, that’s going to manifest itself in higher cross-asset volatility.
“Taking a step back, my phase 2 ‘Financial Conditions Tightening-Tantrum’ stage remains ‘live'”, Nomura’s Charlie McElligott writes in his Friday note, before delivering the equation (as it were):
Fed normalization + increased Treasury supply + higher cost of borrowing in money-markets / an accelerated year-end “funding squeeze” = lower USD liquidity = enhanced cross-asset volatility.
McElligott goes on to reinforce the dollar shortage dynamic outlined above, calling it a “vicious cycle”:
“Dollar Shortage” thesis of 1) Fed hikes, 2) QT / balance sheet run-off and 3) massive uptick in Treasury Bill issuance (due to the enormous forward budget deficits) all rapidly removing USD liquidity…is now seeing additional catalysts for acceleration of the Dollar Rate squeeze / Front-End spasms.
All of that, Charlie notes, is “converging further with an accelerated rush for year-end funding as money-markets strain, with LIBOR fixes going mental MTD, a gapping wider in Commercial Paper and FRA-OIS with yesterday being especially acute [and] another bout of EU banking-stress theoretically further contributing to the ‘grab’ for Dollars in Euro cross-currency basis.” Here’s a visualization (obviously you’re looking at what’s happened in all three from late September through current):
Finally, McElligott asks if EDZ9Z0 is about to invert again, which, he reminds you, “would be indicative of the Rates market pricing-in a marginal Fed EASING at some point in 2020.”
For now, though, the “loco” Fed is still priced to tighten in 2020 despite sinking homebuilders. #SAD!