King Dollar Tipping Point
By: Doug Noland
Saturday, March 7, 2015
The objective of the Fed's extraordinary policy course over the last six years has been to spur risk-taking, asset market reflation, stimulative wealth effects and resulting economic recovery.
Superficially, Federal Reserve monetary inflation appears to have worked. Yet beneath the facade exist extreme imbalances and maladjustment. U.S. and global securities markets have been incredibly distorted. The American and global Credit addiction has only worsened. Such harsh realities cannot be disregarded forever.
Fed policymaking has provided a competitive advantage to financial assets over real economy investment. Rate, monetization and liquidity policies have afforded competitive advantage to speculation at the expense of savings. The overall outcome should be of little surprise:
speculative excess, asset Bubbles and financial engineering galore. And as the Fed falls further behind the curve, Bubble excess turns conspicuous. Mark Cuban blogged this week, "Why This Tech Bubble is Worse Than the Tech Bubble of 2000." CNBC had a Friday segment, "Bubble Trouble in Biotech?" From Bloomberg, also on Friday: "Biotech Keeps Rising as Investors Worry 'End Is Coming'". There is as well greater recognition of Bubble excess that has enveloped corporate debt and derivatives markets.
These days, confirmation of the multi-asset class "Granddaddy of All Bubbles" thesis is apparent about everywhere.
Meanwhile, the global situation - markets, economies and geopolitics - turns progressively unstable. At this point, I am highly confident in my thesis that the global Bubble has been pierced (with profound ramifications!). This view is supported by the self-reinforcing nature of the collapse in energy and commodities prices along with faltering EM currencies.
At the same time, general risk aversion and destabilizing "hot money" exodus have been held at bay by the unprecedented central bank liquidity slushing around the global financial "system." Typical contagion effects have yet to attain momentum. The bullish view holds that policymaking has lessened global systemic risk. I instead believe unprecedented policy-induced distortions have created a bursting dam dilemma. EM securities prices remain completely out-of-whack when compared to the unfolding reality. Acute EM systemic fragility has been masked by central bank policies and historic speculative excess.
A Friday afternoon Bloomberg headline raised a pertinent issue: "Why the Strong Jobs Report May Have Caused the Stock Market to Tumble." I'll attempt an explanation.
First of all, the bond market was clobbered. The June long-bond futures contract was slammed for over three points, with yields rising 16 bps (to 2.46%). Ten-year Treasury yields jumped 13 bps, with yields up a notable 25 bps for the week. Two-year government yields increased eight bps Friday to 0.725% (high since December), and December Eurodollars jumped nine basis points to 0.865%.
The conventional view holds that Friday's strong non-farm payroll report increases the odds of a June rate increase. Importantly, the markets must face the uncertainty of a now rapidly approaching reversal after six years of unprecedented easy "money." And while the markets remain confident the Yellen Fed will approach "normalization" with the most cautious little baby-steps imaginable, the key market issue at this point is the great uncertainty associated with years of policy-induced market excess and distortions. It's worth noting that EM bonds suffered much more dramatic Friday losses than Treasuries.
Friday trading saw South African yields surged 25 bps, Colombia 20 bps, Turkey 18 bps, Brazil 15 bps, Mexico 16 bps, Hungary 25 bps and Poland 17 bps. And EM currencies took one on the chin.
Friday action saw the Mexican peso fall 2.0%, Brazilian real 2.0%, Czech Koruna 1.9%, Bulgarian lev 1.7%, Hungarian forint 1.7%, Romanian leu 1.7%, South African rand 1.7%, Colombian peso 1.5% and Polish zloty 1.4%.
From my perspective, Friday may have provided The Tipping Point for King Dollar. The Dollar Index jumped 1.3% during Friday's session to the highest level since 2003. The dollar is now in its most powerful advance since King Dollar's heyday back in the late-nineties. The King Dollar speculative dynamic is also turning highly destabilizing.
Interestingly, at the top of the Periphery Fragility List, Brazil and Turkey saw their currencies this week hammered 7.3% and 4.4%, respectively. Brazilian (real) 10-year bond yields surged 69 bps to 12.97%. Brazilian stocks were hit for 3.1%, giving back all 2015 gains. Turkish (dollar) yields jumped 37 bps this week to the highest level since December (4.68%). Turkish stocks sank 4.6%, also to the low since December.
Despite all the talk of global deflation risk, Brazil and Turkey (among others) have inflation problems. Bloomberg: "Brazil Posts Fastest Annual Inflation in Almost a Decade." Consumer price inflation has been running above 9% in Turkey for much of the past year. Rapidly devaluing currencies now exacerbate inflationary pressures - the ugly old vicious cycle taking hold (that the printing press can't rectify).
For the most part (excluding Ukraine, Venezuela and Russia), EM bond markets have held their own - even in the face of faltering EM Bubbles. I'll Credit this feat largely to the Fed's intransigent zero-rate policy; BOJ and ECB liquidity injections; Chinese fiscal and monetary stimulus; and, in general, huge interest-rate differentials to "developed" bonds coupled with a massive (and expanding) pool of global speculative finance. And as King Dollar pressured commodities and EM currencies, global deflationary fears were fanned. This ensured that the dovish Fed stayed put at zero, which accommodated "Bubble On" and resulting runaway Bubbles throughout U.S. securities markets.
Domestic and global fragilities ensured unrelenting "do whatever it takes" monetary stimulus from the ECB and BOJ that, when coupled with U.S. excess, provided ample fuel for a more globalized "Bubble On."
But the global pool of speculative finance became too massive and unwieldy, while yen and euro devaluation got out of hand. Global securities markets became too leveraged. The resulting King Dollar Dynamic ensured that global "hot money" flooded into U.S. asset markets (stocks, bonds, real estate, tech, biotech, energy, private businesses, etc.). Reminiscent of the late-nineties, this dynamic became a self-reinforcing Bubble. The stronger the dollar, the more pressure on EM - inciting flows out of the faltering Periphery to the bubbling Core.
Considering the U.S. financial and economic backdrops, rates - Fed funds to long-bond - are much too low. The prospect of the Fed commencing rate "normalization" only throws more gas on King Dollar. This applies more pressure on EM currencies and commodities, which further stokes King Dollar.
The King Dollar Tipping Point comes when EM markets turn disorderly - currencies and bonds. Disorderly is spurred by the prospect of companies, financial institutions and countries not having the wherewithal to service dollar-denominated obligations. And be mindful of critical market psychology: King Dollar ensures that investors in dollar-denominated debt are for a while willing to overlook a lot of EM fundamental deterioration. There comes, however, a Tipping Point where investors begin to fret the ability of the EM debtor to service debts and stabilize economies while avoiding the printing press. There comes a time when nervous speculators move to hedge exposure.
There arrives a Tipping Point where market illiquidity becomes a serious concern.
I believe stocks were hit hard on Friday because a surging dollar and U.S. bond yields now push EM bond markets a big step closer to a disorderly "Risk Off" dynamic. A surprise jump in global yields would portend problematic de-leveraging. I wrote last week that every fledgling Risk Off should now be monitored closely. The global system is much more vulnerable to a liquidity event than is commonly perceived. The global leveraged speculating community continues to struggle with performance - hence is susceptible to losses, de-leveraging, redemptions and more liquidity pressure on global markets. There is also the important issue of de-risking/de-leveraging dynamics throughout the global commodities complex having already negatively impacted the liquidity backdrop.
Moreover, the Fed has ended QE and the pressure is now on the Fed to begin normalizing rates.
It's been an important part of my thesis for a while now that the next meaningful de-risking/de-leveraging episode would be poised for unexpected tumult. Yet each fledgling "Risk Off" was met with comforting words and liquidity from the Fed and global central bankers more generally. But I'll presume (for now) that a 5.5% unemployment rate and elevated securities prices will dissuade the Fed from quickly restarting QE. Meanwhile, ECB and BOJ QE feed an increasingly destabilizing King Dollar, much to the expense of the likes of Brazil, Turkey, Mexico, South Africa, Indonesia, Malaysia, etc.
And there's another King Dollar wildcard worth pondering: China's renminbi. As I touched on last week, King Dollar creates a serious dilemma for Chinese officials. Chinese exporters became less competitive again this week. And there is increasing focus on the possibility of destabilizing outflows from China. Meanwhile, Chinese officials admitted to expanding difficulties, including rising inequality. An ongoing parabolic dollar move might force their hand on de-pegging their currency from King Dollar.
While U.S. stock and bonds were under pressure this week, for the most part spreads were well-behaved. The yen was also under pressure, weakness that supports the "yen carry trade" and global leverage more generally. For Risk Off to attain momentum, I would expect to see spreads widen and the yen to catch a bid. And with Brazil, Mexico, Turkey, South African and others under pressure late this week, markets are on the brink of a full-fledged EM problem - a King Dollar Tipping Point.