Following on from our long standing above consensus optimism about both the sustainability of the synchronised global growth cycle & markets more generally, my colleague Dario Perkins considers below the risks to this rosy scenario of higher real yields (eventually) & in particular the threat of a global ‘dollar shortage’.
If I had to sum up the TS Lombard global macro view in just a few words, it would be this: the current economic cycle is likely to continue (at least) until there is a significant ri se in real yields. To expand on this, I might also say that a rise in real yields would be a necessary – though not sufficient – trigger for the next global downturn. Until yields rise, we still see significant upside for risk assets including equities, even if this means entering clear bubble territory (the ‘meltup’). But rather than go over this view again, I thought I would use this Daily Note to discuss what is becoming an increasingly popular alternative view among certain investors – the idea that an acute shortage of US dollars could derail global markets in 2018, potentially killing the cycle even without a rise in yields. While this prognosis seems far too gloomy, the underlying analysis highlights some important risks that we will need to keep an eye on in 2018.
There has been a lot of talk about a ‘dollar shortage’ over the past couple of years, linked to certain FX and money markets behaving in unusual ways. Attention has focused on the breakdown of ‘covered interest parity’ (CIP), the closest thing we have to a physical law in international finance. When CIP no longer holds, investors are missing out on risk-free returns and market arbitrage has broken down. As we explained in a recent Macro Picture, while these pressures have become particularly noticeable since 2015, the ‘dollar shortage’ is not a new idea – it dates back to the start of the Dollar Standard in the 1940s. Economists realised that the US faced a potential conflict between domestic and international policy objectives (Triffin’s dilemma) and would need to run persistent current account deficits in order to supply the world with sufficient USD liquidity. Some worried that the Dollar Standard would become increasingly unstable, generating a series of boom-bust credit cycles. Those concerns returned in 2008.
Yet the world’s desire for dollars extends far beyond its reliance on US trade deficits. With the dominance of global capital markets and, in particular, the emergence of the ‘Eurodollar system’ – a ubiquitous term that now covers both offshore dollar deposits and global banks’ wholesale dollar transactions – global finance created an explosion in dollar liquidity between the 1960s and 2007. This ended with the subprime crisis, after which the Eurodollar system has struggled. New regulations, which came into effect in 2015 have compounded these problems, restricting non-US banks’ dollar funding. With the system increasingly reliant on Federal Reserve liquidity, some commentators think the dollar shortage could become more acute in 2018, particularly when the FOMC steps up its Quantitative Tightening programme. There are even some who warn about a repeat of the 2008 crisis, when funding sources suddenly disappeared and global banks scrambled for dollar liquidity. If you have four hours to spare, you might check out this excellent set of podcasts called ‘Eurodollar University’.
These risks seem overblown, not least since Fed QT (and the end of ECB QE) will supply new forms of collateral to the banking system, easing the safe asset shortage. The Federal Reserve also has much of its post-crisis monetary architecture still in place, including swap lines capable of providing emergency USD liquidity. But we agree it will be important to monitor this situation in 2018-19. Investors should watch the trade-weighted dollar index particularly closely, as the strains in money markets become more intense (cross-border lending dries up) during times of dollar appreciation. The Japanese banks also provide a potential pressure point, having built up considerable USD funding gaps – similar to what European banks were doing in the run-up to the subprime crisis. Could a liquidity problem at Japanese banks turn into a solvency problem? This depends on the quality of the assets they hold. To the extent they have contributed to China’s credit splurge, there are clear risks. But official data suggest the global banking system is not overly exposed to China – suggesting much of the bubble has been funded domestically.
The best way to monitor these risks is to follow the ‘cross-currency basis’, a simple guide to how far Covered Interest parity has broken down. While this blew out in the final weeks of 2017, causing concern among investors, it has since rebounded – suggesting ‘year-end’ effects were to blame. A larger, sustained widening in the basis, particularly next autumn when the Fed steps up its QT programme, would be a clearer threat to our view that higher long-term yields are needed before we should worry about the end of the current macro cycle.
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