June 10. Dollar Liquidity
“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.” RBI Governor Urjit Patel in a June 3, FT op-ed
Days later, Bank of Indonesia Governor Perry Warjiyo echoed the same sentiments. Several emerging markets have found it necessary to raise rates in order to deal with capital outflows, including India and Indonesia. We’ve already encountered turmoil in Argentina and last week it was Brazil’s turn to roil markets, with the Bovespa having plunged 14% in the past couple of weeks.
Correlation is not necessarily causation, but the chart below shows several currencies that have come under pressure, and it appears as if the damage has mostly occurred since the start of the year, with the new tax package and associated repatriation. As the USD generally weakened throughout 2017, it was good for emerging markets. The rally in DXY starting in April exacerbated declines in EM currencies, and now appears to be causing substantial stress. In mid-May Fitch warned about EM vulnerability due to high levels of debt.
Patel didn’t mince words, warning of potential crisis. This week, the US treasury auctions 3’s, 10’s and 30 year bonds on Monday and Tuesday, in size of $68 billion. Of this amount, $44 billion is NEW borrowing. In May’s auctions, the new cash raised from the same maturities was $34 billion. At that time I had expected a significant concession in order to absorb the supply. However, the rise in yields didn’t occur before the auctions, but rather afterwards in mid-May, and the same pattern could easily ensue this time, (with the FOMC and ECB meetings providing additional complications). Clearly, increased treasury supply is absorbing dollar liquidity, but in a speech May 8, Powell more or less dismissed the Fed’s influence on EMEs, and noted that the Fed had been quite transparent regarding intentions. From the speech, “Much of the discussion of the spillovers of U.S. monetary policy focuses on their effects on financial conditions in emerging market economies (EMEs). Some observers have attributed the movements in international capital flowing to EMEs since the Global Financial Crisis primarily to monetary stimulus by the Fed and other advanced-economy central banks.4 The data do not seem to me to fit this narrative particularly well.”
Let’s backtrack for one second to see where yields were prior to the last 3,10, 30 auctions. On Friday, May 4, I marked 5’s at 2.78%, 10’s at 2.944 and the 30y at 3.114%. On the week just ended, 5y was 2.777, 10y 2.937 and 30 yr 3.082, nearly the exact same levels. Will the extra supply translate into higher yields? Maybe not. Perhaps the added stress on EM simply creates a situation where there’s more demand for safe haven assets. Continued pressure on Italy translates the same way. In some ways it has seemed as if US equities, particularly big tech, had been the beneficiary of safe haven flows even though such rallies were normally referred to as ‘risk-on’. But given Trump’s snub to the G-7 communique and increased trade rhetoric regarding autos, it’s likely that equity markets will take a step back early in the week.
When the Fed hikes on Wednesday, the Fed effective is likely to be extremely close to the rate of inflation. Through May, the Fed Fund effective rate was 1.70%, so even if the IOER is raised less than the 25 bp FF target, FedEff will be closing in on 2%. As telegraphed by Brainard on May 31, the Fed is likely to alter ‘stale’ language in the statement, which had previously read, “…the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” This line may be removed entirely, with additional modification to this phrase: “the stance of monetary policy remains accommodative…” to indicate a more neutral posture.
The risks are that the dots will be revised up and that inflation projections could be inched higher. In Dec 2017, the 2018 FF projection was essentially for three hikes to 2.1% with a further rise to 2.7% in 2019. In March of this year, the 2018 projection stayed at 2.1, but 2019 moved up to 2.9. In many ways, these forecasts are related to the EDZ18/EDZ19 euro$ calendar spread. In Feb through March, EDZ8/EDZ9 spread ranged between 30 and 37 bps. The high close in May was 41.0 and now it’s back at 34.0. The red/green euro$ pack spread in March was around 14 bps just before the FOMC meeting and is now just above 8. I think there’s a chance that the 2018 FF projection could move to 2.2 or 2.3. Coupled with a change in language signifying less accommodation, this could result in a flattening of the very front end of the curve and might also be perceived as additional risk for capital outflows from EM.
The Fed released its Flow of Funds Z.1 report last week. One interesting statistic is noted by Doug Noland who writes the Credit Bubble Bulletin.
Household Net Worth (Assets less Liabilities) surged $1.028 TN during Q1 – surpassing $100 TN ($100.77 TN) for the first time. Household Net Worth inflated $6.630 TN (7.0%) in four quarters and a stunning $13.959 TN (16.1%) the past two years. Household Net Worth-to-GDP, a key stat in Bubble Analysis, ended Q1 at a record 505% of GDP. For comparison, this ratio closed the seventies at 342%, the eighties at 378%, the nineties at 445% and 2007 at 459%. A bonus stat: Household Net Worth ended Q1 about 50% higher than the peak from Q2 2007 ($67.744 TN).
I am not quite sure how to think about net worth being 5x as large as GDP. How is it that ‘wealth’ grows so much more rapidly than ‘income’? I think that might make sense if productivity was extremely strong, but that hasn’t been the case. In the end, wealth must boil down to the present value of the future stream of earnings or of benefit, so this statistic just seems to be another manifestation of a discount rate that is currently quite low. A low discount rate makes balance sheets look more robust than they might actually be. Is the tide about to go out? Perhaps, we’re about to re-visit our underlying assumptions, and head for, as Anthony Bourdain’s series was aptly named, Parts Unknown.
I hadn’t seen much of that particular series, but I did watch an episode where Bourdain visits West Virginia coal country (link below) and transforms his own set of biases.
https://www.dailymotion.com/video/x6inwh4
“Here in the heart of every belief system I’ve ever mocked or fought against, I was welcomed with open arms, by everyone. I found a place both heartbreaking and beautiful, a place that symbolizes and contains everything wrong and everything wonderful and hopeful about America.”
OTHER MARKET THOUGHTS
In Brainard’s recent speech, she noted risks associated with Italy, Emerging Markets, Trade. However, until those risks actually spill over, the domestic economy appears quite strong, with increasing inflation trends and solid labor metrics. So the Fed is likely to maintain its steady course, which means continued quarterly hikes. In the short term, as alluded to above, I think that’s bearish for the front end with an additional chance of increased funding pressures.
Implied vol was extremely well bid into the close of Friday’s session. Perhaps not unexpectedly as we have G7, N Korea, Central bank meetings and US inflation data this week, along with auctions. ED straddles were up 1-2 bps Friday. For the sake of comparison, EDU8 9750^ settled 14.0 on Friday from 12.5 on Thursday. On May 16 it settled 13.0. EDZ9 9712^ settled 47.5, and on May 16 the EDZ9 9687 atm straddle settled 47.0. So in the past 3 and ½ weeks short premium trades aren’t paying. Certainly this is partially due to the near term calendar, but the market may be giving more weight to tail risks in the second half of 2018. If this latter idea is correct, then VIX back down to 12.2 is misguided.
| 6/1/2018 | 6/8/2018 | chg | |
| UST 2Y | 246.5 | 249.2 | 2.7 |
| UST 5Y | 273.6 | 277.7 | 4.1 |
| UST 10Y | 289.1 | 293.7 | 4.6 |
| UST 30Y | 304.5 | 308.2 | 3.7 |
| GERM 2Y | -62.8 | -65.1 | -2.3 |
| GERM 10Y | 38.6 | 44.9 | 6.3 |
| JPN 30Y | 71.4 | 70.9 | -0.5 |
| EURO$ Z8/Z9 | 31.5 | 34.0 | 2.5 |
| EURO$ Z9/Z0 | 6.0 | 5.5 | -0.5 |
| EUR | 116.59 | 117.71 | 1.12 |
| CRUDE (1st cont) | 65.81 | 65.74 | -0.07 |
| SPX | 2734.62 | 2779.03 | 44.41 |
| VIX | 13.46 | 12.18 | -1.28 |
https://www.ft.com/content/e193381a-64c1-11e8-bdd1-cc0534df682c
