Monthly Archives: March 2020

Dollar shortage vs. dollar funding stress

19 Thursday Mar 2020

Posted by in FX

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I think we should distinguish between dollar shortage and dollar funding stress. We have a lot of the latter and much less of the former compared to any previous crisis.

‘Dollar shortage’ is your classical EM currency crisis stemming from a balance sheet currency mismatch: borrow in dollars to fund a non-dollar asset. Cue Mexico’94, Asia’97, Russia’98, Brazil’99, Turkey’01, Argentina’01. There are fewer of them nowadays.

A ‘dollar funding stress’ stems from borrowing in dollars to fund a dollar asset – that’s the problem today (see for ex. Z. Pozsar’s latest). It feels like the old EM currency crises because a lot of dollar assets are owned by foreigners but it is very different at the same time as there are no balance sheet currency mismatches.

That distinction is important because the market is treating it as if it is a dollar shortage crisis while it is a classic ‘Mark-to-market (MTM)’ crisis. If the dollars were borrowed through the swap market, refinancing would widen the basis and move the currency. If the borrowing was in the loan/bond market, it would be a credit story, not a currency story.

There is also a break even price for dollar funding above which foreigners would choose to sell the dollar asset and repay the loan, rather than continue to finance it (probably they will have to top up if the MTM has moved too much from where they bought it). All this is a very different situation from a dollar shortage crisis whereby they would need to sell a local currency asset and actually convert proceeds into dollars.

The Fed is well aware of all this and has acted very swiftly to respond to the recent strengthening of the dollar by improving massively the terms of the five existing central bank swap lines and by adding today nine more to the frame. The extraordinary moves in some DM currencies, notably NOK and AUD, has also prompted the respective central banks to verbally intervene (Norges) or ‘not to rule out’ intervention (RBA).

Some people have mentioned to me that a new Plaza Accord is needed. I am not so sure. In my opinion, it would be counterproductive. From a behavioral point of view, a weak dollar is not necessarily beneficial for US assets given that a big chunk of them is owned by foreigners. Just like a worsening of the dollar funding terms may push these people to sell, so could an attempt to substantially weaken the dollar. We shouldn’t forget a small but very much overlooked fact of the 1987 stock market crash: on the weekend before Black Monday, the US Treasury Secretary threatened to devalue the dollar.

Bottom line is that a dollar funding crisis should have a much smaller effect on weakening the local currency than a dollar shortage crisis. The market does not need a dollar devaluation, rather a stable dollar. Policy makers should make sure foreign dollar funding does not blow up. And finally, market pundits should be careful exaggerating the dollar shortage issue.

Fed’s crisis response may endanger the dollar

13 Friday Mar 2020

Posted by in Equity, FX

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The response from the two most powerful central banks could not have been more different. ECB is innovative, using fine tuning and precision in tiered rates and targeted lending; Fed is still throwing the kitchen sink at the market by flooding the banking system with liquidity.

ECB is also going more direct partially because the banking system there is in shatters, but also because it makes sense regardless. Plus, the ECB is already taking credit risk by buying corporate bonds. Surely, the next step is literally direct credit lending and massively expanding the ECB counterparty list.

Fed is still stuck in the old model of credit transmission, entirely relying on the banking system. That model died in 2008, in fact, even before that, in the early 2000s, as the first Basel rules came into effect and the shadow banking system flourished.

Post 2008 it became much more common for financial institutions, like PE etc. to get in the credit loan business. Needless to say, this carries a big risk given that they don’t have access to Fed’s balance sheet like the banks.

The US banking system is now flooded with liquidity. If the new repo auctions are fully subscribed, this will double banks’ reserve balances and will bring them to the peak post the 2008 crisis. But do banks need that liquidity?  It does not seem so: the first $500Bn repo auction yesterday had just $78Bn of demand. But that liquidity from the Fed is there on demand, plus the central banks swaps lines are open, and as of March 12, none has been drawn. And finally, the foreign reverse repos pool balance at the Fed has not shown any unusual activity (no drawdowns). All this is indicating that USD liquidity is at the moment sufficient, if not superfluous, so, it should have a negative effect on USD, given long USD has been a popular position post 2008.

All this liquidity, however, may still do nothing to stocks, as seen by their performance into the close yesterday, because balance sheet constraints prevent banks from channelling that liquidity further into the US economy where it is surely needed. From one hand, the Fed is really pushing on a string when it comes to domestic dollar liquidity, but, on the other, it is providing more than plenty abroad. 

Risky assets are still a sell on any bounce, and the USD is probably a sell as well, as the Fed will be forced to keep cutting but it is now running a risk of foreign money exiting long established overweight positions in US assets. 

Keep Calm and Stay at Home

11 Wednesday Mar 2020

Posted by in China

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China went through three main changes to stem the spread of the Coronavirus:

  • Quarantine
  • Lockdown
  • Rationing

In the ‘West’, we’ve added ‘Self-quarantine’ first, in some countries. Others are in the delusional phase of ‘Delay’, because, apparently, they are worried that ‘people will get bored and break out of self-isolation if it last too long’. In fairness, there is a logical reason to delay because as China and Italy will find out, the economic costs of going through those stages above are enormous. That reason is that scientists could be able to find vaccine in time. That is a very dangerous bet for the infections grow exponentially, and if a vaccine does not come soon enough, the health care system of the country will be overwhelmed (and no, the coming warm weather in the Northern Hemisphere is unlikely to slow down the infections, like in the normal flu, because this is not the normal flu, and infections have shown to grow also in hot weather like Singapore or Iran). Then, not only the economic costs but also the societal costs will be unspeakable.

Finally, one other country’s leader still thinks this virus could be ‘fake’…

WHO went on a fact-finding mission to China and released a report on February 28. The report is unequivocal:

“China’s bold approach to contain the rapid spread of this new respiratory pathogen has changed the course of a rapidly escalating and deadly epidemic.”

There are also stories about two different strains of the virus, apparently stemming from the desire to explain higher number of infections/deaths in some countries and lower in others. I don’t know. To me this is simply a function of testing more people and proper reporting. It also makes sense to run with that story in countries which have chosen to be in the ‘Delay’ stage. Occam’s razor: even if there were two strains, I don’t see how they can be country-specific.

“Everywhere you went, anyone you spoke to, there was a sense of responsibility and collective action, and there’s war footing to get things done”

~Bruce Aylward, the epidemiologist who led the WHO mission to China 

There is no doubt that even in the best cases in the ‘West’, the ones which added ‘Self-quarantine’, it will take longer to get through this also because of culture, different societal structure and more liberal thinking. For example, the talk in Italy is that if things don’t start improving in a couple of weeks the country might have to go to the next stage, ‘Rationing’ (only one person per household can leave the house to replenish supplies).

After decades of general peace, no major natural disasters in the ‘West’, and used to thinking only in financial terms, we cannot comprehend what is happening to us and are unable to quickly make the right decision how to proceed forward. For almost everybody, understandably, limiting our movement is at minimum uncomfortable and for a lot of people, unacceptable. To go through rationing is unimaginable (even though for some of us, who grew up behind the Iron Curtain, this was a feature of daily life). But seriously, it’s not like we have been asked to go to war, like our grandparents; we are just told to sit on the couch at home and play video games!

It can’t be that bad, can it?

Oil: OPEC’s Russian Roulette

08 Sunday Mar 2020

Posted by in Energy

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I did not expect the ‘no deal’ from OPEC+ largely because of the urgency of the immediate demand destruction from the Coronavirus.

In hindsight, Russia’s reaction was quite rational. What about the Saudis?While they are still the lowest cost producer, the precariousness of the political situation there (see developments this weekend) makes me believe that they have a lot more to lose from the current status quo. Russia may be at a disadvantage when it comes to cost, but after years of sanctions, it is more prepared to withstand lower prices for longer.

As a result, I see Saudis’ attempt to lower prices on their products as a ‘bluff’, which, if called, they will have to fold. On the long run, lowering prices can only be counterproductive for them. First of all, it will affect their fiscal balance. Second, it will reinforce Russia’s (supposed) game plan (to push US shale out of the game) and hurt US, a Saudi ally. Therefore, this is at best an attempt to gain marginal market share; it would be extremely imprudent to begin a price war.

While indeed Trump has been very vocal on the benefit of low oil prices to US consumers, the sands started shifting in 2019 as the US became a net exporter of petroleum towards the end of the year: all of a sudden, Trump started extolling US energy independence. Would the US president be eager to keep a campaign promise to end US reliance on foreign energy? If so, he would now need to balance low oil prices with the risk of the US shale oil industry going bust. Therefore, I would not be surprised if the Saudis get a call from the White House should oil prices continue to plunge and that threatens the viability of US energy production.

I think the short-term market reaction this week will be brutal, but this is very different from 2014-2016 when we had similar producers’ dynamics and oil hit $30. First, inventory build-up back then was +230mbd, today it is -1.5mbd. Second, shale was in the upswing then, while now it is on the backfoot: oil-well declines are much bigger, costs are higher, and capital is scarcer. 

I was bullish WTI at $45 last weekend partially because I expected the markets to bounce on sentiment, which they did, but more importantly, because the price reflected a demand-supply imbalance discounting a sharp drop in demand from the Coronavirus effect – there was, I thought, a decent cushion. Moreover, it is my view that either China will use the oil price drop to simply buy more oil, or that economic activity in China, being the marginal swing buyer of oil, will slowly come back – or rather much faster than in the West thanks to the actions the authorities there took to contain the outbreak.

Oil eventually hit $30 in 2016 but did not stay there long. It is much more difficult to model today the demand destruction from the Coronavirus but also there should be some marginal energy demand coming from the digital medium as all these people staying/working from home get online (ICT energy use is now more than half travel energy use, and it is growing very fast). Supply side is always easier to model, and it shows that compared to 2014, inventories are much lower, shale is largely out, and specs are short.

We should not underestimate that lack of liquidity/margin calls work both ways depending on positioning (as per gold sell-off a week ago) That means one needs to watch the newswires and trade rather than invest. That’s what I am doing.

Toto, I’ve a feeling we’re not in Kansas anymore

03 Tuesday Mar 2020

Posted by in Asset Allocation, China, EM, Equity, Monetary Policy, Politics

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This worked out quite well. Too well given the G7 “strong and coordinated response”. Let’s not kid ourselves, unless they can build a hospital in six days, this is going to be highly inadequate.

As if rates going negative was not enough of a wake-up call that what we are dealing with is something else, something which no one alive has experienced: a build-up of private debt and inequality of extraordinary proportions which completely clogs the monetary transmission as well as the income generation mechanism. And no, classical fiscal policy is not going to be a solution either – as if years of Japan trying and failing was not obvious enough either.

But the most pathetic thing is that we are now going to fight a pandemic virus with the same tools which have so far totally failed to revive our economies. If the latter was indeed a failure, this virus episode is going to be a fiasco. If no growth could be ‘forgiven’, ‘dead bodies’ borders on criminal.

Here is why. The narrative that we are soon going to reach a peak in infections in the West following a similar pattern in China is based on the wrong interpretation of the data, and if we do not change our attitude, the virus will overwhelm us. China managed to contain the infectious spread precisely and exclusively because of the hyper-restrictive measures that were applied there. Not because of the (warm) weather, and not because of any intrinsic features of the virus itself, and not because it provided any extraordinary liquidity (it did not), and not because it cut rates (it actually did, but only by 10bps). In short, the R0 in China was dragged down by force. Only Italy in the West is actually taking such draconian measures to fight the virus.

Any comparisons to any other known viruses, present or past, is futile. We simply don’t know. What if we loosen the measures (watch out China here) and the R0 jumps back up? Until we have a vaccine or at least we get the number of infected people below some kind of threshold, anything is possible. So, don’t be fooled by the complacency of the 0.00whatever number of ‘deaths to infected’. It does not matter because the number you need to be worried about is the hospital beds per population: look at those numbers in US/UK (around 3 per 1,000 people), and compare to Japan/Korea (around 12 per 1,000 people). What happens if the infection rate speeds up and the hospitalization rate jumps up? Our health system will collapse.

UK released its Coronavirus action plan today. It’s a grim reading. Widespread transmission, which is highly likely, could take two or three months to peak. Up to one fifth of the workforce could be off work at the same time. These are not just numbers pulled out of a hat but based on actual math because scientist can monitor these things just as they can monitor the weather (and they have become quite good at the latter). And here, again, China is ahead of us because it already has at its disposal a vast reservoir of all kinds of public data, available for immediate analysis and to people in power who can make decisions and act fast, vert fast. Compare to the situation in the West where data is mostly scattered and in private companies’ hands. US seems to be the most vulnerable country in the West, not just because of its questionable leadership in general and Trump’s chaotic response to the virus so far, but also because of its public health system set-up, limiting testing and treating of patients.

Which really brings me to the issue at hand when it comes to the reaction in the markets.

The Coronavirus only reinforces what is primarily shaping to be a US equity crisis, at its worst, because of the forces (high valuation, passive, ETF, short vol., etc.) which were in place even before. This is unlikely to morph into a credit crisis because of policy support. 

Therefore, if you have to place your bet on a short, it would be equities over credit. My point is not that credit will be immune but that if the crisis evolves further, it will be more like dotcom than GFC. Credit and equity crises follow each other: dotcom was preceded by S&L and followed by GFC.

And from an economics standpoint, the corona virus is, equally, only reinforcing the de-globalization trend which, one could say, started with the decision to brexit in 2016. The two decades of globalization, beginning with China’s WTO acceptance in 2001, were beneficial to the USD especially against EM, and US equities overall. Ironically, globalization has not been that kind to commodity prices partially because of the strong dollar post 2008, but also because of the strong disinflationary trend which has persisted throughout.

So, if all this is about to reverse and the Coronavirus was just the feather that finally broke globalization’s back, then it stands to reason to bet on the next cycle being the opposite of what we had so far: weaker USD, higher inflation, higher commodities, US equities underperformance.

That’s my playbook.