One month ago, before the recent collapse in China’s stock market and the plunge in emerging market currencies, the head of the Reserve Bank of India, Urjit Patel wrote an FT op-ed in which he issued a stark warning: “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 currently sees the Fed’s balance sheet shrink by $40BN/month and is set to peak at a rate of $50BN/month by Q4, 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.
Then, one week ago, Morgan Stanley doubled down, and predicted that the Fed’s balance sheet may not shrink as much as most people expect: “We believe that the Fed will halt the normalization of its balance sheet by September 2019 and start growing it again in 2020 to ensure that the effective fed funds rate remains within the range the Fed targets.”
We expect the Fed’s System Open Market Account (SOMA) portfolio to be just above US$3.8 trillion at the end of 2020. In contrast, primary dealers and market participants polled by the New York Fed place a 68% and 60% probability, respectively that the SOMA portfolio will be smaller than US$3.5 trillion at the end of 2020.
Now, a third strategist has joined the chorus: according to Viktor Shvets, head of Asia strategy at Macquarie Commodities and Global Markets, who spoke to Bloomberg TV on Wednesday, “financial markets are flashing a warning to the Federal Reserve that the global economy cannot withstand its monetary tightening, and will in coming months force a halt to the campaign.”
“The problem is the Federal Reserve right now is destroying money, destroying roughly $50BN ” as its bond holdings mature without replacement as part of QT, Shvets said. “They will be forced at some point in time over the next three to six months to stop reducing the size of their balance sheet.”
Adding this two cents on the stock vs flow debate, Shvets said that while the Fed has been focusing on the appropriate size of its balance sheet as it continues to shrink its asset holdings, investors are far more concerned by the incremental change in monetary flows: “It is clear, from the market, flow is far more significant than the size of overall accommodation.”
Ultimately, Shvets’s core thesis is that without loan growth, the system will grind to a halt as borrowing has become such an inherent part of the global economy that markets and growth cannot withstand higher borrowing costs. And by shrinking the monetary base of the dollar, the Fed is imposing a global tightening.
The risk of excessive tightening and a jump in rates not only affects global markets, but also domestic: as we showed last week, Interest Payments on the Federal Debt, have recently jumped to an all time high of $558 billion, a number which will grow, first slowly then fast, as rates keep going higher.
“The world and financial markets will force them to: a) stop trying to increase the cost of capital; and b) stop reducing the balance sheet at the same pace,” said Shvets, who previously worked at banks including Deutsche Bank AG and Donaldson Lufkin & Jenrette.
Which ultimately leads us to the dystopia envisioned by Shvets: a world of pervasive NIRP and QE as central banks do everything in their power to prevent the zombie system, which now only exists thanks to incremental debt, from collapsing.
“All cost of capital globally, eventually, will have to go negative” because of the “degree of leverage and financialization that we have globally.”
Watch the interview below:
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