MATASII DECEMBER 2018 NOTES: THE EURODOLLAR SHORTAGE
CHANGING SENTIMENT TOWARDS THE US
- The dumping of the dollar is a process that is clearly underway. There has been a steady uptick in the number of countries dumping significant portions of their dollar holdings as a result of them having been targets of American sanctions and financial bullying in the “post 9/11 world,
- The United States maintains sanctions on all of its target nations such as Iran, Syria, North Korea, Russia, and others. But the US also threatens its “allies” with sanctions if they dare act rationally on the world stage or refuse to follow American dictates,
- Countries like Russia feel they can no longer trust the US dollar-dominated financial system since America is imposing unilateral sanctions and violates World Trade Organization (WTO) rules. They feel the dollar monopoly is unsafe and dangerous for the global economy.
THE DRIVING FORCE
- Aggressive Americans sanctions and financial bullying over the past few decades,
- Countries tired of being victims of the empire,
- Those who dare act rationally on the world stage or refuse to follow American dictates,
- Those who desire a “multipolar” world,
- Those seeking to expand their own empires,
- Those who smell blood is wafting through the air.
- Major countries (China, Russia, Turkey, Iran) are Liquidating their US Treasuries, one of the world’s most actively-traded financial assets, has recently become a trend among major holders.
- Increasingly transacting trade in non US Dollar Currencies,
- Finding alternatives to the US "SWIFT" system,
IMPACT TO INVESTORS
- Interest rates will most assuredly go up,
- The potential for widespread inflation and devaluing of the currency
EXPECTED AMERICAN REACTION
The United States has used its status as a method of financing itself into maintained prosperity, the loss of that status would remove that privilege. Instead, the United States would be forced to either:
- Knuckle under to the dictates of the financiers that will have the country on its knees or
- Do what it should have done all along – nationalize the Federal Reserve and begin issuing credit stimulus and imposing across-the-board tariffs on imports.
A MULTI-POLAR WORLD
- The US economic system, partially as a result of becoming an empire with all its requisite destabilizations and wars, mostly a result of Free Trade, and partially a result of private central banking among a host of other factors, has been sacrificed on the altar of globalism.
- Aggressive behavior on the financial, political, and military fronts has thus created a world seething with anger and hatred at the United States, who is now willing and able to begin weakening the dollar dominance in hopes for the creation of a new “multipolar” world out of the ashes of the old “American” one.
- There are no signs that anyone in the American government is either prepared to defend against the dollar collapse or to
- prevent it. In fact, all signs point to the possibility that such a collapse is desired by the Anglo-financier community.
EURODOLLAR LIQUIDITY SENDING UNAMBIGUOUS WARNING SIGNAL IF CENTRAL BANKS DON'T SOON RESPOND
It unambiguously clear that there is a strong relationship between the change in global USD-liquidity (in the form of M1) and the performance of the global stock market, where liquidity leads the stock market by an average of eight months.
- The world is now crossing that critical threshold where the consolidated global central bank balance sheet is shifting from a source of liquidity to a drain on the global (and fungible) monetary system,
- It is only a matter of time before the need for continued "flow" (not "stock)" of liquidity manifests itself in sharply lower asset prices,
- The rate of change in liquidity is now the lowest it has been since the financial crisis, absent a fresh boost to global $-liquidity, Nedbank expects this relationship to hold and "as a result the risk of further downside potential for stock markets across the world remains intact."
- Where the shortage of liquidity is already manifesting itself, Nedbank claims, is in the rising spread of USD-denominated Emerging Market corporate debt, where the spread is close to a breakout level. To Nedbank,"this is the "canary in a coal mine for risk assets."
Every single time the total change in net central bank assets has dipped into the red, it lasted only briefly before some financial crisis typically ensued, forcing central banks to resume liquidity injections to maintain market stability.
WHY THE RUSH TO MERGE TWO BIGGEST GERMAN BANKS: DEUTSCHE & COMMERZBANK?
A funding problem for global markets isn’t solved by global banking giants of any national flavor, it begins there
- Discussions of a tie up of two banks with large overlapping businesses signal dwindling hope that Deutsche Bank will be able to break out of a vicious circle of declining revenue and sticky expenses. The stock has dropped more than 50 percent this year and broken through multiple record lows on the way down, while funding costs have continued to rise.
- The only thing, CBK has going for it at the moment is its largest current shareholder – while around 55% of shares are held by institutional investors, including vehicles like hedge funds and mutual funds, the most concentrated in any single owner is the ~15% stake held by the Federal Republic of Germany,
- This is related and connected to Germany’s vulnerable external financing requirements (“dollar short”),
DEUTSCHE BANK'S FAILED GAMBLE
- Deutsche plunged headlong into the riskiest assets – global junk, including US corporates as well as US$ EM junk (Eurobonds).
- The Leveraged Debt Capital Markets (LDCM) franchise combines a premier high yield bond market business with diverse debt financing capabilities
- LDCM is a leader in European leveraged finance and is at the forefront of innovation in all aspects of the leveraged debt capital markets and is one of the few franchises that can price, structure, underwrite and distribute senior, mezzanine and high yield transactions on both sides of the Atlantic.
- As DB makes plain, there are only “5-6 FIC players left” and there exist exceptional barriers to entry ensuring smaller banks stay smaller. This oligarchical structure is perfect for DB in “attractive products”, such as high yield and leveraged lending (both can fairly be termed the modern incarnation of junk).
- FIC, or FICC as its alternately known, is the guts of global money dealing in the eurodollar game.
- DB saw opportunity to be one of the few left even more exposed to US and EM junk and the FICC plumbing, if you will, behind it.
- We’ll likely never know the full details, including potential collateral transformations and the risks of them, but we can easily and reasonably connect how if US and EM junk are having a bad year (or four), “funding costs have continued to rise” makes perfect sense
It seems as if the world’s Eurobond binge of 2016 and 2017 was only enough to stabilize the bank’s position, and stock price, until that market turned violently wrong starting last December. By January 2018, it was clear another EM crisis was on deck and the Eurobond market was going to be front and center in it.
TURMOIL IN EMERGING MARKETS DUE TO EVAPORATION OF US$ FUNDING
Turmoil in Emerging Markets? Blame it on the "double whammy" of the Fed's shrinking balance sheet coupled with the dollar draining surge in debt issuance by the US Treasury.
That's the message from the current Reserve Bank of India, Urjit Patel, who writes that "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." But does that mean that the Fed is not to blame for what increasingly looks like another budding EM crisis? Not at all: according to Patel, the dollar funding shortage "upheaval" stems from what he sees as the confluence of two significant events of which the Fed’s balance sheet reduction is one, while the second is the dramatic increase in US Treasury issuance to pay for Trump's tax cuts; what is notable is that both events are drastically soaking up dollar liquidity.
As a result, Patel blames a lack a coordination between the Fed and Treasury on the adverse flow through across global funding markets as a result of this decline in dollar liquidity, and writes that "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."
Putting these two parallel processes - which threaten to materially impair dollar funding markets - in context, on one hand there is the so called "Quantitative Tightening", or the gradual decline in the Fed's balance sheet which is set to peak at a rate of $50BN/month by October, while at the same time US net Treasury issuance is set to jump to $1.2 trillion in 2018 and 2019 to cover the forecasted budget deficit of $804BN and $981BN in 2018 and 2019, respectively.
And in a curious coincidence, the withdrawal of dollar funding by the Fed in monthly terms, as it reduces its reinvestment of income received, is proceeding at roughly the same pace as that of net issuance of debt by the US government. Furthermore, both processes are open ended which means that over the next few years, the government’s net issuance will stabilize, albeit at a high level, whereas the Fed’s balance-sheet reduction will keep rising.
Both are terrible news for Emerging Markets, which are in desperate need of reversing the ongoing dollar outflows; however as long as Trump continues to make America great, and funds said stimulus with excess debt issuance, emerging market turmoil is virtually guaranteed.
As Patel further explains, this unintended coincidence has proved to be a “double whammy” for global markets, and especially emerging markets, largely as a consequence of one key event: the evaporation of dollar funding, not only from sovereign debt markets but in short-term funding markets as well as the recent spike in the Libor-OIS spread showed.
This has manifested in a sharp reversal of foreign capital flows out of Emerging Markets over the past six weeks, often exceeding $5bn a week, resulting in a sharp drop in emerging market bonds, stocks and currencies.
And here, for the first time this tightening cycle, a prominent foreign central banker has accused the Fed of stirring trouble for emerging markets, with its ongoing tightening, and specifically, the balance sheet reduction coupled with the Treasury debt issuance surge, to wit:
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.
Patel's advice? Immediately taper the tapering, or rather, the Fed should "recalibrate its normalisation plan, adjusting for the impact of the deficit. A rough rule of thumb would be to reduce the pace of its balance-sheet contraction by enough to damp significantly, if not fully offset, the shortage of dollar liquidity caused by higher US government borrowing."
Incidentally, the various pathways described by Patel were conveniently laid out by Deutsche Bank's Aleksandar Kocic two weeks ago, and which we explained in "Why The Soaring Dollar Will Lead To An "Explosive" Market Repricing."
Of course, the Fed has a choice: it can simply ignore the ongoing crisis it is causing for Emerging Markets - after all the Nasdaq just hit a new all time high - but in that case Powell risks a broader contagion, first in EMs and then everywhere else. Instead, reducing the pace of balance sheet reduction...
would help smooth the impact on emerging markets and limit effects on global growth through the supply chains that span both developed and emerging economies. Otherwise, the possibility will increase of a “sudden stop” for the global economic recovery.
Patel's punchline: if left unchecked, the EM turmoil "might hurt the US economy as well. Circumstances have changed. So should Fed policy. It would still reach the same destination, but with less turmoil along the way."
The irony: one look at the Fed's balance sheet shows that it has barely declined, and already reputable foreign central bankers are demanding the Fed stop the pain.
One can only imagine the chaos and turmoil in EMs (and then DMs) in four months time, when not only the peak of the Fed's monthly shrinkage hits some time in October, but when for the first time since the financial crisis, global central bank liquidity will shift from a net injection to a net drain and then accelerate as both the ECB and BOJ proceed to taper their own Fed monetization.
EURODOLLAR FUTURES: POWELL MAY FIGURE IT OUT SOONER, HE WON'T HAVE ANY CHOICE!
- Today, central banks aren’t banks at all; they are pop psychologists plying the role of hand holder. This is a very different set of circumstances, this expectations management. Thus, what matters is not what a central bank does in markets, it doesn’t really do much, rather what does matter (to Economists) is how you think of it,
- By the middle of May, Powell turned clearly “hawkish” while global markets were rocked by a gigantic collateral call of a still-undetermined nature. Eurodollar markets would notice; even the FOMC would notice what with its later hesitant reference to “strong worldwide demand for safe assets.”,
- One of the largest, deepest perhaps most important markets in the world was saying Powell’s Fed was going to “raise rates” and then regret it,
- The market believes there is a non-trivial chance the Fed is making a forecast error, it just doesn’t know when officials will finally get around to realizing it. Central bankers are extremely stubborn ideologically and are the last to figure things out,
- Over the last several weeks, however, alarms and concerns have multiplied. To say nothing about the real economic case oil contango presents. It isn’t a good one, to put it mildly,
- This market is now hinting that perhaps the FOMC will realize their big forecast mistake sooner than previously thought,
- This market is now hinting that perhaps the FOMC will realize their big forecast mistake sooner than previously thought.