Nomura’s McElligott: ‘Messy’ Dollar Funding Markets May Argue For Fed ‘Power Cut’ – But There’s A Catch

Although most expect just a 25bp cut from the Fed on Wednesday, some are still in the 50bp camp.

Morgan Stanley, for instance, has 50bp (with the communication shifting to “continue to monitor”) as their base case. That informs the bank’s call for outright longs in 2-year Treasurys. The risk, the bank says, is a 25bp cut with a reversion to the “patient” language (that combination would constitute a hawkish surprise).

The Fed itself went to extraordinary lengths to walk back expectations for a 50bp cut just ahead of the blackout. John Williams’s efforts to extoll the virtues of going big when operating near the lower bound were apparently seen as a misstep with the potential to push the market towards adopting 50bp as the base case ahead of the July meeting and so, the New York Fed issued an unprecedented “clarification”. (Donald Trump loved Williams’s remarks, by the way.)

Read more on the Williams communications faux pas: Fed Officials Succeed In Thoroughly Confusing Markets

“We suspect the FOMC was uncomfortable with the market moving toward a 50bp cut and wanted to push the market back to a 25bp baseline”, BofA wrote, following the July 18 debacle, on the way to saying that Williams “unintentionally misguided the markets” and because the blackout period started the following day, “the NY Fed had no other choice but to issue a press release [because] had they remained silent, the market would be convinced of a 50bp cut”.

So, is there a case for 50bp beyond the obvious? That is, outside of the extant literature which shows that acting aggressively when operating near the zero lower bound is generally good policy, is there a more nuanced, technical argument?

Well, yes.

“A scenario where the Fed would shock the markets with a 50bps cut would likely come down to their (unspoken) concerns around 1) USD strength (as a clear headwind to achieving their inflation goal and as a headwind to US exporters) which comes part and parcel with 2) Dollar funding / liquidity ‘tightness’ into a slowing global economy”, Nomura’s Charlie McElligott writes, in a Tuesday note.

Charlie cites the Treasury refunding preview (Mnuchin plans to borrow more than twice as much in Q3 as previously tipped) and juxtaposes the expected deluge of supply against “dealer balance sheets loaded to the gills, increasingly price-sensitive domestic investors and foreign real money who remains sensitive to the cost of the almost punitive’ FX hedge”. Consider that in conjunction with the following from Nordea’s Lars Mouland, out Tuesday as well:

US politicians worked hard to land a budget and debt ceiling suspension deal before their summer recess. Previous debt ceiling extensions have come after weeks of bickering between democrats and republicans, so this pre-summer agreement was a pleasant surprise. With the debt ceiling suspended until 2021, the US Treasury yesterday announced their intention to rebuild their cash buffer to 350 bln in September and 410 bln by year end. The buffer is currently just below 200 bln, and the 150bln increase over the next two months implies a big draing on the commercial banking system similar to what we saw in the spring of 2018 (see figure 2).

With all of that in mind, McElligott runs through a series of indicators that show the dollar plumbing backdrop remains “messy”. A lot of this will sound familiar. Here are 5 factors McElligott lists in his Tuesday missive:

We have seen meaningful FRA-OIS widening since the end of May (3m nearly doubling from 16bps to current 30bps) which is likely to stay elevated in coming weeks, in light of the aforementioned issuance / collateral soon to hit the market;
Cross-Currency Basis for US Dollar funding is now too ‘cat (more expensive for foreign entities to fund in Dollars–i.e. 3m EURUSD from +4.75 on Jan 9^th to today’s -25.5bps);
We see the anomalous dynamic of Fed Funds (effective rate) trading above IOER (and despite a number of IOER cuts throughout QT), which is a “free money arb” for banks that should not exist because in theory, banks should lend at the higher FF rate instead of parking money with the Fed where they are paid “lower” IOER–but are not doing so;
Despite the Fed’s dovish pivot since early January to reverse the “financial conditions tightening tantrum” of 4Q18, the SOMA runoff has continued unabated throughout 2019, where said “supply shift” (more going to private investors and not Fed) has continued upward pressure on repo rates vs OIS (tighter funding);
And finally / similarly, as bank reserves have continued to shrink (the supposed basis for the Fed’s stance change) in addition to the now “known” / imminent Bill-issuance spike potential impact across money rates, SOFR volatility / spread to IOER is too likely to remain elevated (tighter funding)

So, if you’re wondering why the greenback remains so stubbornly resilient in the face of an overtly dovish Fed, market expectations for rate cuts and recent signs of weakness in the US economy (prior to a rebound in some of the most recent data), you could simply point to still tight dollar funding conditions.

Here’s a bit more from the same Nordea note cited above:

Since news appeared about the upcoming debt ceiling deal, the market has started pricing for tighter USD liquidity. SEP IMM 3M Libor-OIS has moved from 20bp to 28 bps, and 3M EURUSD basis has moved from -16bps to -26bps, a combined increase of 18bps for the price of 3M USD for foreign accounts. With uncertainty about how much the FED will cut rates, it is hard to pin all of this change on the debt ceiling, and it is also hard to forecast the total market impact this change in USD liquidity will have. Normally 100bln tighter liquidity corresponds to a roughly 10bps combined move in Libor and basis. The change in Treasury cash buffer means the change in USD liquidity will be about 300 bln (from -100 to +200 in figure 2), so we could see another 10bps of market reaction before is it fully priced. Historically, the changes is Treasury cash buffer have had a larger impact in Libor-OIS than in fx basis, and we foresee that this will be the case this time as well.

With the US economy seemingly set to outperform the rest of the world in virtual perpetuity (e.g., things just continue to get worse in Europe and global PMIs are in the doldrums on balance), it’s not hard to envision more dollar strength, especially as the FOMC’s global counterparts continue to pivot dovish. The visual in the left pane shows YoY relative growth between the US and G7 economies versus YoY changes in the trade-weighted dollar. In the right pane is a lagged dollar chart with non-petroleum import prices (inverted).

(Deutsche Bank)

As McElligott goes on to write, “this ‘strong Dollar’ dynamic is an inflation headwind [and] an economic/exporter headwind”, something the Fed is no doubt acutely aware of. Of course, Donald Trump is acutely aware of it too (even if he’s blissfully unaware of the extent to which his borrowing binge has, periodically, contributed to tighter funding conditions). “This is now a VERY political headwind to the US Administration”, Charlie goes on to say.

What’s the problem with a 50bp cut? That is, what’s the catch?

Simple: The risk is that if the Fed does “go big” in order to alleviate/mitigate some of the factors/dynamics mentioned above, the market interprets that as a sign that the July move is a one-off “insurance” cut, and therefore less likely to morph into the kind of honest-to-goodness easing cycle everyone wants to see.