The Dollar Index - The Global Wrecking Ball
Updated: Apr 30, 2020
There is an old folklore in the islands of South East Asia along the lines of “when the sea disappears, run for the higher ground”. The sea has disappeared for financial markets in recent weeks, but what is coming is a tsunami of central bank liquidity and government spending. The has been a lot already but clearly not enough; otherwise markets would have started to calm. The coronavirus is the accelerant to a huge structural change that is now underway.
Below is an exercise in content curation including observations, charts, quotes, tweets and links to try and give investors as much colour as possible about what is happening and where possible our interpretation of what it means.
Dollar Index going vertical is a wrecking ball for markets and economy
The Dollar Index
The US dollar is screaming higher due to massive global shortage. The dollar is the world’s reserve and major transactional currency. The demand for dollar funding is colossal but only the US Federal Reserve can provide dollars. It needs to do so in sufficient quantities for not just the US but the world.
This is what the recently announced swap lines with other central banks are designed to do.
We are reminded of the 2016 paper from the BIS which warned on the dangers of a stronger USD.
“Given the dollar’s role as barometer of global appetite for leverage, there may be no winners from a stronger dollar.”
Comment: After initially selling off the dollar is going straight up. This rise needs to be averted and fast but global central banks but mainly by the Fed. Some sort of agreement along the lines of the Plaza Accord https://en.wikipedia.org/wiki/Plaza_Accord is possible but bottom line the Fed is going to have to provide all the dollars the world needs in a timely fashion.
The Federal Reserve Balance Sheet
The Fed’s balance sheet has already started exploding higher, going from $4.1tn to $4.6tn in the last three weeks and yet it has still not been enough. This is just the beginning. $10tn by year end? Either the Fed will keep growing its balance sheet at a fast-enough rate to put a lid on the dollar and a floor on risk assets or it won’t. If it doesn’t then the “beatings will continue until morale improves” and the whole system collapses. Until it does, USD cash will continue to outperform everything. Once it does equities should bounce but gold should be the main beneficiary. Left unchecked a super spike in the dollar index that crushes everything else is possible but, in our opinion, likely to be short lived.
“Risk-free” assets sell off during the crisis and amount of negative yielding deb globally collapses.
TLT – The ishares 20+ Year Treasury ETF
Bloomberg Barclays Aggregate Negative Yielding Debt
In what is morphing into a multi-generational crisis and equities are down 30% in 4-weeks, which is unsurprising given what has passed. However, it is inconceivable that the long treasury, THE risk-free asset, fell 22% in 8 trading sessions (before bouncing) and the amount of negative yielding debt collapsed from $14tn to $8tn in the height of the equity sell-off. Normally you would expect the complete opposite. Possible reasons why?
a) People need cash and will sell ANYTHING to get it.
b) Markets are looking at the gargantuan government deficits coming down the tracks and balking at financing them.
In the hear and now reason a) is the driver. Assuming a degree of control is regained the longer-term b) will take over as the driver. The US was running a $1tn deficit before the crisis erupted. This will now be >$3tn. Who is going to buy all these treasury bonds? Foreigners?
Foreign Official Purchases/Sales of US Treasuries
Foreign central banks haven’t bought treasuries since late 2014, shortly after China said it was no longer in their interests to accumulate fx reserves (aka buy US treasuries).
That leaves the US private sector which has been the main buyer to fund US deficits in recent years. But they do not have any balance sheet left. The only buyer is the Fed in a direct monetisation (printing money to fund governments). A $3tn deficit is $250bn a month of Fed asset purchases BEFORE the requirements of the private sector. If foreign central banks start selling what they hold rather than just not buying Treasuries (to raise USDs?) then the numbers will get even bigger. The US Net International Investment Position is currently negative $12tn, which means foreigners own $12tn of US assets which could in theory be sold to raise USD.
No wonder foreign creditor nations have been buying gold hand over fist for years. These dynamics were in place before the Coronavirus hit, but they were moving at a glacial pace. The virus and its fallout are just the accelerant.
Perhaps we now know why central banks have been buying gold hand over fist ever since the financial crisis.
IMF World Gold Reserve Holdings
Real Yields are rising as inflation expectations collapse faster than bond yields and financial conditions have tightened dramatically.
US 10 Year Real Yields
Bloomberg Financial Conditions Index
Real rates have tightened inflation expectations have fallen faster than bond yields. This hasn’t been helped by the collapse in oil prices triggered by the Saudi/Russia bust up.
In recent days bonds yields have risen despite the sell-off in equities.
The US (and all other countries) are experiencing much tighter financial conditions during an economic crisis. Central banks and governments need to do all they can to reverse this. They have done a lot already, but we continue to believe this will pale compared with what is coming. Rising real yields are a headwind to gold prices. Markets are viewing the current crisis as a major deflationary shock. Once the scale of the combined fiscal and monetary response becomes clear and when added to the major supply disruption, we think markets will reverse this move in real yields which will be bullish for precious metals.
Yield curve control: coming to a bond market near you.
Yield curve control occurs when central banks set not only short rates but commit to buying unlimited amounts of bonds at pre-specified rates along the yield curve.
Yield Curve control in WWII
Source: Luke Groman FFTT
The coronavirus has prompted the kind of government response usually reserved for wartime. In wartime normal economic conventions go out of the window. Authorities cannot allow interest rates to rise under any circumstance. Japan is already pursuing this policy. Governments around the world will cede control over the quantity of money to control its price. In the medium term, this is negative for bonds on a real (although not nominal basis as governments that can print money will never miss a payment), relatively better for equities and rocket fuel for physical gold and related equities.
Risk Parity strategies blowing up as bonds fall with equities.
Risk parity in its simplest form exploits the (historic) negative correlation between bonds and equities and leverages the bond component to make it as risky (in terms of volatility) with the equity part. With bonds collapsing with equities together this trade has blown up spectacularly taking some very large players with it.
Risk Parity Index – Target 10% Volatility
Risk parity is not the only strategy under pressure.
There are all sorts of rumours swirling of bailouts.
The UK and the US go all-in to save their economies. Germany follows suit.
The UK is planning to pay 80% of wages of those who can’t work.
A Democtratic Senator has just proposed minting two $1tn coins to be held by the Fed in exchange for a $2tn credit to the Treasury to be distributed to the population.
Even Germany is going all in.
Q: Where does all this money
A: Thin air.
Economies closed and markets open is a potentially lethal combination.
So far, the authorities have balked at the idea of closing markets.
But with economies at a standstill and borders closed, markets risk becoming a cash machine to replace the lost cash flows from the real economy. This will continue until.
a) financial asset prices are all priced at zero.
b) a combination of Central Bank printing and Government Spending replaces the cash flows.
c) markets are closed.
We think authorities are acutely aware of the risks of a), trying their best to execute b) but it that fails or happens with a delay, will resort to c) until b) is fully operational.
Markets are still in SELL EVERYTHING mode. This needs to be stopped FAST one way or another.
For now, the two priorities are getting the virus under control and keeping the economy afloat. Once they are achieved then secondary factors kick in. US-China relations were at a pretty low ebb before this event. Once the dust has settled and with a US election looming, there is no doubt who the President feels is to blame for this. This could get very ugly.
Some big sectors are going to need a bailout. Airlines for example. Airlines are important – almost utilities in modern economies. Airlines need to be bailed out, as do airline employees. Airline shareholders/bondholders? Not so much.
Since 2014, the four biggest US airlines have bought back (rough numbers) $42bn in shares whilst generating $37bn in free cash flow. They have paid their senior executives hundreds of millions. The largest shareholders of the US airlines are Primecap Management and Berkshire Hathaway. Should the US government be bailing out Uncle Warren?
- Most people are underestimating the amount of money that is going to be printed in order to try and avoid a global economic collapse. We are going to see central bank balance sheets explode to truly eye-popping levels and the only asset that they have on their balance sheets that can rise enough to collateralise that balance sheet growth is gold.
- If the Fed won’t or can’t provide all the dollars the world needs, then eventually the world will do if for them. For at the right gold price, there are all the dollars the world requires to meet all the nominal dollar debt obligations.
- When the dust settles people are going to wonder where all this money came from. Once the taboo has been broken you can never go back. The link between taxes and spending has been severed and in a world of huge wealth disparity, severed for good.
- I have spent this morning trying to assemble the words to try to convey my long-term bullishness on gold and related equities. I’ll have to get back to you.
- Governments and their central banks have only just started a process of self-dealing so their economies do not have to fully mark to market the liquidation value of their debts and the assets that collateralise them.
- In the eye-of-the-storm in this gut-wrenching volatility, all investors want to own is cash and ideally US dollar cash. However, as we come out the other side, they should realise that it will be a global imperative that debts are devalued in real terms and in a fiat money system, cash is just a “debt token”.
- Possession of property will not shift but purchasing power will. Purchasing power will be lost by those with “debt tokens” and leveraged financial assets denominated in them. Purchasing power will be gained by those with unleveraged stores of value, scarce resources and productive assets.
- A portfolio of 100% cash will give short-term security in exchange for long-term loss of future purchasing power. I portfolio of 1/3 cash (to meet liquidity, and dampen volatility), 1/3 strategic equities (that meet the requirements listed in the point above) and 1/3 gold and gold related equities, introduces short-term risk and volatility in exchange for keeping you whole in the future.