This research piece was sent to me by Martin Enlund who is the author and Chief FX strategist at Nordea Markets. It is an interesting and worthwhile read. I apologize to Mr Enlund for leaving out some charts which do not translate well to my low rent blog.
Via a fully paid up subscriber (Martin Enlund):
Well I don’t know why I came here tonight,
I got the feelin’ that somethin’ ain’t right,
I’m so scared in case I fall off my chair,
And I’m wonderin’ how I’ll get down the stairs
– Stealers Wheels – Stuck in the Middle With You
Caveat: this mail has nothing to do with the Fed’s most recent decision, but provide food for thought on USD liquidity and markets potential dependency thereof. For Nordea’s take on yesterday’s FOMC decision, read here.
The liquidity elephant in the room
Why is it that, every time the Fed stops its money-printing programs, or initiates the end of such programs (the tapering process), global nominal activity eases, inflation expectations drop, the USD appreciates, volatility rises and long-term bond yields plummets? (chart 1)
It could be that either i) the Fed’s QE programs have been more important than thought, as they have provided abundant USD liquidity to the rest of the world (which needs a lot of it, see our pieces on Quantitative Tightening), or ii) the programs haven’t very important at all: the 2009-2015 relationship between QE and both real and financial developments is mostly noise.
The first argument infers that the world is much more dependent on USD liquidity than commonly thought. Why could this be? Being the only true safe-haven currency, and the currency most often used in pricing and transactions, countries will want to have FX reserves of which the most must be in USD (having e.g. EUR, CHF or SEK would help little in a truly adverse scenario). Maybe world trade cannot grow without a rising supply of USD / without FX reserves growing? It could be added that six years of zero-interest rate policies and QE program may have made the rest of the world more dependent on USD than in earlier times (due to the USD now being used as a funding currency to a greater extent, which suggests higher structural demand for USD in coming years – for instance in FX reserves). In short, if the market needs to re-price the availability of USD liquidity, it would be positive for the price of the USD, but also disinflationary for the world via its effects on world trade and global activity. (A consensus economist would not agree with any portion of this).
According to the second line of thinking, the “QE on/QE off” phenomenon is just a bogus correlation: the positive effects from a drop in interest rates (caused only marginally by QE expectations) have caused a boost to global activity just as the Fed had formally initiated a QE program. This bounce in activity eventually led to higher bond yields, of which the delayed negative effects just happened to kick in as the Fed ceased its new money-printing program. Looking ahead, a leading indicator based on changes in interest rates does indeed global activity should pick up and indeed accelerate soon after Easter this year (chart 2). If this is what will play out this year, all will be well – and the ECB will congratulate themselves on work well done! (even though they should not).
If the world is hooked on USD liquidity, how should we think?
The first theme is the more interesting of the two (goldilocks scenarios seldom are, at least not for the FI & FX crowd). If the rest of the world is more dependent on USD liquidity than commonly believed, then the recent disinflationary process will continue until either i) the Fed launches a new QE program providing liquidity, or ii) US domestic demand grows quick enough so as to widen the current account deficit materially (through which the rest of the world will obtain USD liquidity), or that iii) the USD appreciates enough so that it via price effects provides a widening of the current account deficit. It does seem as if the pattern since the eighties suggest that at least some crises (LatAm, Asia) were “solved” with a widening of the US current account deficit (chart 3)
Last year’s dramatic oil price developments fit quite nicely with this non-consensus conjecture. The US non-petroleum trade deficit has been widening since 2010, but since the US has been growing more self-sufficient in terms of energy, the trade balance has actually narrowed – as have the current account deficit. The rest of the world would have been able to obtain more dollar liquidity since 2010 if not for the structural changes in the energy sector (chart 4). The drop in oil prices should however help the US trade deficit to widen as the US shale industry lowers its oil production (when?), which would then prompt wider trade and current account deficits.
EM FX reserves held in custody at the Fed have been declining since September, in a manner reminiscent of what happened after then-Fed chairman Bernanke triggered the global taper tantrum in 2013 (chart 5).
In this light, maybe Singapore’s recent move to ease monetary policy, or China’s decision on liquidity and its changes to CNY fixings are just natural consequences of the rest of the world trying to compete for now less ample USD liquidity.
If true, we should expect further broad USD appreciation, and for the US to import more of the world’s disinflation as a result. Keep an eye on EM FX reserves, if they start growing briskly it should be a sign of a positive turning point as the consumer of last resort – the American one – will finally be back to bail us all out.