Authored by Neels Heyneke and Mehul Daya via Nedbank,
It’s not just Turkey, the dollar liquidity storm is ahead of us – buckle up.
Bottom line: Should Global $-Liquidity and Global financial conditions fail to improve or even contract further we can expect a deflationary environment to materialise. In this environment we prefer to maintain defensive investment portfolios i.e. Cash over bond over equities.
We cannot stress enough the importance of the 95 level on the US Dollar index. A confirmed break above this level will mark the beginning of the next risk-off phase. More importantly, it is not the value of the US Dollar Index per se that matters, but rather what it represents – i.e. expansion/contraction in the pool of money.
Astonishingly for us, there is a high correlation with causality in our opinion between every financial market cycle (VIX) and with the story count in which the world “DOLLAR LIQUIDITY” appears. This is another example of how the availability of US Dollars has a profound effect on financial markets.
Probably the most defining photo in decades to come…
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The political consequences of this photo gets a lot of coverage, we however would like the point out the importance of this photo with regards to the current USD-based monetary system that the world so heavily relies upon.
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Trump and his “bring back my money” home will suck-up all the USD from the rest of the world – the next crisis will be centred around the shortage of USD’s which the world heavily relies on.
A symbiotic economic relationship grew post the fall of the Berlin wall between the developed and developing economies with the rise of globalization. The US was a major consumer of the world’s production and the consequence was a $11 trillion cumulative trade deficit with the rest of the world – during this period the world’s USD monetary base grew from 4 to 16% of global GDP.
A consequence of globalisation was disinflation which allowed central banks to cut policy rates (discount factors). This helped stimulate economic growth and fuel asset prices. The destructive inflationary episode of the 1970’s meant monetary policy became focused on consumer inflation targeting.
This caused investors to became obsessed with the monetary policy cycle. The market did not appear to pay attention to the extraordinary growth in the USD monetary base instead focussing on measuring the price of money (CPI) and not the quantum. This is still the case today. What resulted was all asset classes out-performed GDP as the rising tide of $-liquidity lifted all ships.
Now that the USD monetary base or ‘tide of liquidity’ has started to recede central banks are starting to play an active role in controlling the quantum (viaQE), and not just the price of the monetary base (via policy rates).
We believe that with this shrinking USD monetary base it becomes as important to understand liquidity, global flows and the role the dollar plays as the reserve currency in order to identify the right investment destination.
The challenge for investment manager will be for investors to identify the optimal asset class (beta) in a receding ‘tide of liquidity environment’.
On top of the ballooning monetary base we mentioned above, the debt creation process went through a major evolutionary process of its own and gearing in the system grew dramatically. The fractional banking system has been around for 600 years and banks traditionally lend out the same money 14 times. Just before the 2008 GFC global banks lent out the same money in excess of 40 times!
The reason being, on top of the regulated banking sector there was the shadow banking sector that regulators failed to monitor. There was also the Eurodollar system – the dollar banking system outside the US, that no regulator monitored. All in all, there was more money and credit in the system than regulators, economists and analysts were aware of because it did not show up in consumer inflation. The important question is where is this excess money/debt. The answer lies in asset inflation and how asset prices managed to out-perform the real economyfor30-years.
It is not just the global real economy that cannot afford a shrinking base of the money pyramid. The indebted balance sheets of the world cannot afford the asset deflation that will go hand in hand with shrinking money supply.
In a volatile world where the growing US dollar monetary base of the last 30-years is changing, we believe investors should pay more attention to the source of money.
Oops – USD debt outside the US is massive and is systemic.
Post WWII global trade took off and the importance of the dollar grew, this accelerated in the late 1980s. Today 60% of the world’s countries are linked to the dollar. The US GDP share of the world economy has however declined from 27 to 18% over the same period – remember the US is the only provider of USD base money.
Should global growth become less synchronized the US deficit will shrink. This will provide less USD into the global financial system resulting in a shortage of dollars. Tighter monetary policy from the Fed, a higher Fed funds rate and shrinking of the Fed’s balance sheet, will further slowdown USD creation.
The shrinking dollar monetary base will slow down the credit creation process because the economy is so highly geared. This shrinking pool of dollars will cause the dollar to rise. The strengthening USD means higher offshore USD funding, this will hurt USD indebted nations/corporations.
In this environment i.e. tighter global financial conditions, the infamous carry-trade will come under pressure and the misallocation of credit will be revealed. EMs will be at the centre of the misallocation of credit.
As the US trade deficit fuelled the global monetary base from 4 to 16% of global GDP, and the process of Financialisation began – the gap between the real economy and financial markets accelerated from the late 1980’s accelerating up out of an 80-year old band.
The tail is wagging the dog. Next crisis will be in the financial markets and not the real economy – as has been the case for many decades now.
A slowdown in debt creation will not bode well for financial assets.
Market view:
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We conclude the world needs an injection of Global $-Liquidity soon to improve global financial conditions. If the cavalry fails to arrive (QE4, material uptick in global growth) we can expect global financial conditions to contract and the USD to appreciate. In this scenario, a stronger USD and rising offshore USD funding costs will lead to a risk-off phase. Dollar indebted countries, corporations and the carry-trades will be most impacted.
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The US Dollar index is going up – because the Eurodollar system is stalling.
The monetary base as percentage of global trade (see above) started to roll over post the 2008 GFC. The dollar started to rally as the total pool of dollars started to shrink driven by the financial system deleveraging.
With global interest rates at historical low levels, covered interest parity – the prominent driver of currencies – also started to break down.
It is a meaningful technical analysis signal that the dollar index failed to break back into the bear trend at 88 that has been in place since the 1985 Plaza Accord.
The US dollar index has now reached our first target level at 95 and we expect a consolidation phase over the next few weeks. A sustained break above this level will project a move to above the 2017 high at 103.80.
The most important chart for EM / DM asset allocation is centred on changes in USD liquidity.
EM’s are on the verge of another 1998.
Since the 1980’s there has been major cycles of money flow moving in and out of emerging markets. We believe dollar liquidity played a major role in these cycles stemming from commodities being traded in dollars.
It was not just the Fed that bailed out the markets in 2009. The big rally in EMs post the GFC was on the back of the commodity run which was fuelled by the Chinese ‘bail-out’. The rising commodity prices (and petro-dollar balances) added many dollars to the financial system. Commodity prices peaked in 2011 and fell until the end of 2015 and EM’s started to under-perform. The rising liquidity that triggered the risk-on phase of 2016-2017 came from the rising oil price ($28 to 78) and the ECB flooding the system. This however came to an end in February 2018.
This relative chart warned in 1994 already that emerging markets were slowing down although the crisis only materialised in 1997/8. In 1998 EM’s especially SE Asia had fixed exchange rates and their currencies could not buffer them against capital out-flows. Most of these countries now have floating currencies and reserves, but post 2008 they have taken on substantial USD debt putting them in the same situation as in 1998.
Hence our concern, if global liquidity does not improve soon EMs will be very vulnerable to major outflows again.
Lastly – if the pool of USD is going to shrink, then the price of USD must rise – i.e. term–premium higher offshore funding will be dreadful for leveraged carry-traders who will de-risk. It is the funding currency that will be forcing them out and not the fundamentals of where the money was invested – exactly what happened during 1H18.
We often face the question, “but where will the money go?” – The answer is nowhere, because most of the funds was never true savings, it was a loan created against some collateral. When the money returns to the source the loaned gets repaid.
Lastly – Get ready for higher funding costs as the pool USD shrinks, the price of USD money will rise too.
With the Fed continuing with interest rate hikes and shrinking of its balance sheet, the US Treasury issuing more debt, absorbing USD flows, China slowing down (dollar creation via commodity cycle), other central banks slowing down QE (roc matters) and a Trump with his “bring back my dollars, jobs home” – the world and financial markets better be prepared for a dollar shortage.
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