-- CLIPPED FROM: 08-14-18 - "Forget About Turkey: Asia Is The Elephant In The Room" --

Back in November 2016, the BIS picked up on a topic we have often discussed over the years, namely the critical role that dollar abundance (or shortage) plays in defining market stress, and going one step further, published a research report which made the striking claim that while the VIX was now dead as an indicator of market risk, it had been replaced with the value of the dollar. 

This is what the Bank of International Settlement said then:

Just as the VIX index was a good summary measure of the price of balance sheet before the crisis, so the dollar has become a good measure of the price of balance sheet after the crisis. The mantle of the barometer of risk appetite and leverage has slipped from the VIX, and has passed to the dollar.

What explains the dollar’s role as the summary measure of the appetite for leverage? In a nutshell... there is a tight “triangular” relationship between (1) the dollar, (2) cross-border bank capital flows in dollars and (3) the deviation from CIP. The key to understanding this relationship is that dollar cross-border capital flows closely track the leverage decisions of global banks. The triangular relationship says volumes about the role of the US dollar in the global banking system, and ultimately how the monetary policy backdrop determines global financial conditions.

Fast forward to this June, when the head of the Reserve Bank of India, Urjit Patel, made a solemn appeal to the Fed: stop shrinking your balance sheet because in combination with the soaring US budget deficit (which requires a surge in new Treasury issuance), you are draining precious USD-liquidity out of the market.

This was the first time this cycle that a prominent foreign central banker accused the Fed of stirring trouble for emerging markets, with its ongoing tightening:

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 earlierthis year, and which we explained in "Why The Soaring Dollar Will Lead To An "Explosive" Market Repricing."

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."

Two months later, the turmoil among emerging markets raging, with the currencies of Turkey, Argentina, Brazil, Russia and even China sliding against the dollar. So far the only part of his prediction that has not manifested, is the contagion from EMs to the US economy.

But that may be only a matter of time, especially if the Turkish crisis spills over into the European banking sector, and from there it crosses the Atlantic.