Tag Archives: #liquidity

Sand on the Beach

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The central bank known as the Fed
Injected more funds, it is said
Than sand on the beach
While they did beseech
The banks, all that money to spread

But lately the numbers have shown
Liquidity, less, they condone
Thus traders have bid
For dollars, not quid
Nor euros in every time zone

A funny thing seems to be happening in markets lately, which first became evident when the dollar decoupled from equity markets a few days ago. It seemed odd that the dollar managed to rally despite continued strength in equity markets as the traditional risk-on stance was buy stocks, sell bonds, dollars and the yen. But lately, we are seeing stock prices continue higher, albeit with a bit tougher sledding, while the dollar has seemingly forged a bottom, at least on the charts.

The first lesson from this is that markets are remarkably capable at sussing out changes in underlying fundamentals, certainly far more capable than individuals. But of far more importance, at least with respect to understanding what is happening in the FX market, is that dollar liquidity, something the Fed has been proffering by the trillion over the past three months, is starting to, ever so slightly, tighten. This is evident in the fact that the Fed’s balance sheet actually shrunk this week, to “only” $7.14 trillion from last week’s $7.22 trillion. While this represents just a 1% shrinkage, and seemingly wouldn’t have that big an impact, it is actually quite a major change in the market.

Think back to the period in March when the worst seemed upon us, equity markets were bottoming, and central banks were panicking. The dollar was exploding higher at that time as both companies and countries around the world suddenly found their revenue streams drying up and their ability to service and repay their trillions of dollars of outstanding debt severely impaired. That was the genesis of the Fed’s dollar swap lines to other central banks, as Chairman Jay wanted to insure that other countries would have temporary access to those needed dollars. At that time, we also saw the basis swap bottom out, as borrowing dollars became prohibitively expensive, and in the end, many institutions decided to simply buy dollars on the foreign exchange markets as a means of securing their payments.

However, once those swap lines were in place, and the Fed announced all their programs and started growing the balance sheet by $75 billion/day, those apocalyptic fears ebbed, investors decided the end was not nigh and took those funds and bought stocks. This explains the massive rebound in the equity markets, as well as the dollar’s weakness that has been evident since late March. In fact, the dollar peaked and the stock market bottomed on the same day!

But as the recovery starts to gather some steam, with recent data showing that while things are still awful, they are not as bad as they were in April or early May, the Fed is reducing the frequency of their dollar swap operations to three times per week, rather than daily. They have reduced their QE purchases to less than $4 billion/day, and essentially, they are mopping up some of that excess liquidity. FX markets have figured this out, which is why the dollar has been pretty steadily strengthening for the past seven sessions. As long as the Fed continues down this path, I think we can expect the dollar to continue to perform.

And this is true regardless of what other central banks or nations do. For example, yesterday’s BOE action, increasing QE by £100 billion, was widely expected, but interestingly, is likely to be the last of their moves. First, it was not a unanimous vote as Chief Economist, Andy Haldane, voted for no change. The other thing is that expectations for future government Gilt issuance hover in the £70 billion range, which means that the BOE will have successfully monetized the entire amount of government issuance necessary to address the Covid crash. But regardless of whether this appears GBP bullish, it is dwarfed by the Fed activities. Positive Brexit news could not support the pound, and now it is starting to pick up steam to the downside. As I type, it is lower by 0.3% on the day which follows yesterday’s greater than 1% decline and takes the move since its recent peak to more than 3.4%.

What about the euro, you may ask? Well, it too has been suffering as not only is the Fed beginning to withdraw some USD liquidity, but the ECB, via yesterday’s TLTRO loans has injected yet another €1.3 trillion into the market. While the single currency is essentially unchanged today, it is down 2.0% from its peak on the 10th of June. And this pattern has repeated itself across all currencies, both G10 and EMG. Except, of course, for the yen, which has rallied a bit more than 1% since that same day.

Of course, in the emerging markets, the movement has been a bit more exciting as MXN has fallen more than 5.25% since that day and BRL nearly 10%. But the point is, this pattern is unlikely to stop until the Fed stops withdrawing liquidity from the markets. Since they clearly take their cues from the equity markets, as long as stocks continue to rally, so will the dollar right now. Of course, if stocks turn tail, the dollar is likely to rally even harder right up until the Fed blinks and starts to turn on the taps again. But for now, this is a dollar story, and one where central bank activity is the primary driver.

I apologize for the rather long-winded start but given the lack of interesting idiosyncratic stories in the market today, I thought it was a good time for the analysis. Turning to today’s session, FX market movement has been generally quite muted with, if anything, a bias for modest dollar strength. In fact, across both blocs, no currency has moved more than 0.5%, a clear indication of a lack of new drivers. The liquidity story is a background feature, not headline news…at least not yet.

Other markets, too, have been quiet, with equity markets around the world very slightly firmer, bond markets very modestly softer (higher yields) and commodity markets generally in decent shape. On the data front, the only noteworthy release was UK Retail Sales, which rebounded 10.2% in May but were still lower by 9.8% Y/Y. This is the exact pattern we have seen in virtually every data point this month. As it happens, there are no US data points today, but we do hear from four Fed speakers, Rosengren, Quarles, Mester and the Chairman. However, they have not changed their tune since the meeting last week, and certainly there has been no data or other news which would have given them an impetus to do so.

The final interesting story is that China has apparently recommitted to honoring the phase one trade deal which means they will be buying a lot of soybeans pretty soon. The thing is, I doubt it is because of the trade deal as much as it is a comment on their harvest and the fact they need them. But the markets have largely ignored the story. In the end, at this point, all things continue to lead to a stronger dollar, so hedgers, take note.

Good luck, good weekend and stay safe
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Overrun

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Our planet, third rock from the sun
Has clearly now been overrun
By Covid-19
Whose spread is unseen
And cannot be fought with a gun

It is certainly difficult, these days, to keep up with the latest narrative about how quickly the virus will continue to spread and when we will either flatten the infection curve or will get past its peak. Every day brings a combination of optimistic views, that within a few weeks’ things will settle down, as well as pessimistic views, that millions will die from the virus and it will be many months before life can return to any semblance of normal. And the thing is, both sets of opinions can come from reasonably well-respected sources. Adding to the confusion is the fact that there is still a huge political divide in the US, and that many comments are politically tinged in order to gain advantage. After all, while it has not been the recent focus, there is still a presidential election scheduled for November, a scant seven plus months from now.

With this as the baseline, it cannot be that surprising that we have seen the extraordinary volatility present throughout markets in recent weeks. And while volatility may have peaked, it is not about to fall back to the levels present two months ago. In fact, the one thing of which I am certain is it will take a long time for markets to settle back into the rhythms that had seemed so pleasing and normal for so many years.

Something else to note is that while central banks seem to have been able to positively impact market behavior in recent days, the cost of doing so has gone up dramatically. For example, during the financial crisis, the widely hated TARP bill had a price tag of $700 billion, clearly a large number. And yet that is one-third of what the present stimulus bill will cost. And the Fed? Well it took them three months in 2008 to expand their balance sheet by $1 trillion. This time it took less than three weeks. And they are not even close to done!

It is the latter point that brings the greatest risk to markets, the fact that the cost of addressing market failures has grown far faster than the global economy. This is a result of the serial bubble blowing that we have seen since October 1987, when the Maestro himself, then Fed Chair Alan Greenspan, promised the Fed would support markets and not allow things to collapse. That inaugurated a pattern of central bank behavior that prevented markets of any kind from clearing excesses because the political fallout would have been too great. But as we have seen, each bubble blown since has had a larger and larger price tag to overcome. The question now is, have we reached the limits of what policymakers can do to prevent markets from clearing? Certainly, they will never admit that is the case, but much smarter people than me have made the case that their capabilities have been stretched to the limit.

It is with this as background that I think it makes sense to discuss what we have seen this week alone! Using the S&P 500 as our proxy, we saw a sharp decline on Monday, over 4%, and then a three-day rebound of nearly 18%! In fact, from its lows on Monday, the rebound has been more than 20%. Many in the financial press have been saying this is now a bull market. My view is that is bull***t. A bull market needs to be defined as a market where prices are rising on the back of strong underlying fundamentals and where long-term prospects are strong. The recent fixation on 20% movements as defining a bull or bear market are completely outdated. Instead, I think the case is far easier to make that we are ensconced in the beginning of a bear market, where the long-term, or at least medium-term, fundamentals are quite weak and prospects are uncertain, at best, and realistically quite negative for the coming quarters. Declaring a bull market on the same day that Initial Unemployment Claims printed at nearly 3.3 million, far and away the highest in history, is ridiculous! I fear that the movement this week in stocks and the dollar, is not the beginning of a new trend, but a reactive bounce to previous price action.

Turning to the dollar, after a remarkable rally in the buck throughout the month of March, it too has fallen sharply during the past several sessions. The proximate cause was the Fed, which when it announced its laundry list of new programs on Monday evening was able to calm immediate fears over a lack of USD liquidity. It appears that the dollar’s two week run of strength was driven by global fears over a shortage of dollar liquidity available coming into quarter end next week. We saw this in the movement of basis swap spreads, which blew out in favor of dollars, and we saw this in the FX forward market, where every price that encompassed the turn was no longer linearly interpolated. But the Fed has thrown $5 trillion at the problem and for now, that seems like it is enough, at least for this quarter. Markets have settled, and the fear over coming up short of dollars has abated for the time being.

But this is not over, not by a longshot. Navigating the next few months will be quite difficult as we are sure to see more negative news regarding the virus, followed by policy attempts to address that news. Until a solid case is made that globally, the peak of the infection curve is behind us, we are going to remain in a tenuous market state with significant volatility.

Finishing with a brief look at the dollar this morning, it is actually having a mixed session. In the G10, NOK continues to be the most volatile currency by far, down 1.3% this morning after an intervention led 14% rally in the past week. Of course, that was after it fell nearly 29% in the previous two weeks! And you thought only EMG currencies were volatile! But the rest of the G10 space shows JPY strength, +0.9%, as repatriation flows help the currency, and then much lesser movements in both directions from the rest of the bloc.

In the emerging markets, the story is similar, with KRW the biggest gainer, +1.8% overnight, as the BOK confirmed its recent activity qualifies as QE, and more importantly, that they will continue to do everything necessary to support the economy. Meanwhile, on the opposite end of the spectrum is the Mexican peso, which has fallen 1.5% this morning after Standard & Poor’s downgraded the country’s credit rating by a notch to BBB and left them on negative watch. The peso, too has had a wild ride this month, declining nearly 6 full pesos at its worst level, or 30%, before rallying back sharply this week by 10% at its peak, now more like 8.2%. Again, the point is that we can expect ongoing sharp movements in both directions for now.

With spot today being month-end, I realize many companies will be active in their balance sheet rolling programs. Forward bid-ask spreads continue to be wider than normal but have definitely moderated from what we saw in the past two weeks. This is the new normal though, so for the next several months, be prepared for wider pricing than we all learned to love.

Good luck, good weekend and stay safe
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