Last October, just as the Fed started shrinking its balance sheet, we published yet another article on what is arguably the biggest threat to not only risk assets, but also the global economy: “The Dollar Funding Shortage: It Never Went Away And It’s Starting To Get Worse Again.“
While hardly a novel problem, we first discussed the return of the dollar funding shortage in March 2015, the fact that global stocks kept rising, and that overall funding conditions remained relatively loose keeping the global economy well-lubricated, prevented said dollar funding shortage from becoming a major concern to policymakers, despite occasional recent hiccups such as the Libor-OIS spread blow out which both we and Citi explained w as a byproduct of a creeping dollar funding shortage.
That has now changed.
In an op-ed published overnight in the FT, a central banker writes that when it comes to the turmoil gripping the world’s Emerging Markets, whether it is the acute, idiosyncratic version observed in Argentina and Turkey, which according to JPM may be doomed…
… or the more gradual selloffs observed in places like Indonesia, Malaysia, Brazil, Mexico and India, don’t blame the Fed’s rate hike cycle. Instead blame 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 visually:
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.
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