The financial media likes to frame the markets into simple, data-driven, cause-and-effect nonsense producing high-frequency asset allocation shifts such as risk-on/risk-off and the great rotation out of bonds and into stocks. They discuss whether money is flowing in and out of these assets and why this may be happening. Market price action is much more complicated than this elementary portrayal, but at the same time, much simpler when broken down to the basic transaction.
On April 8 in Bond Yields Are Falling Because the Consumption Bubble Is Imploding my point was to show that the bond market was discounting something much more complicated than a short term shift in capital allocation, yet the reason behind this discount was as simple as long term adjustment in how the US consumer finances spending.
Consumption and household debt didn't just rise in relation to the size of the economy, they also rose as a percent of income. Credit was used to subsidize income in order to increase spending which in turn drove GDP growth. For decades the US economic growth engine that we all love to brag about has really just been an exercise in consuming stuff we didn't need with money we didn't have. This generational trend is now in reverse and potentially so massive that it transcends monetary and fiscal policy.
Household Debt Vs.Current Account Balance
The following week out of nowhere the price of gold tumbled 6.3% with most of the move occurring on Friday when the metal fell $80. On Monday the selling intensified in an outright collapse as gold fell $130, completing a two-day 14% meltdown. Many participants were struggling to rationalize the selling. Was this simply a byproduct of Bank of Japan QE policy? Was it due to Cyprus' need to sell gold to finance the bailout? Maybe John Paulson's hedge fund was blowing up. Some event attributed the selling to asset allocation into stocks. I knew better.
The consumption bubble implosion thesis is predicated on a very simple concept that will unfold in a very complex manner. Put simply, the US consumer is entering a cycle whereby consumption is no longer financed with assets and credit, and now will be financed with income. The complexity is how this cycle plays out in global financial markets.
The US consumption bubble has been the engine behind global capital flows, and the machine works in a certain way. You can think of the global market as one giant balance sheet. Our deficit is their surplus. Our spending is their income. Our liability is their asset. That's all simple. What's more complex is how the capital flow reverses and what it means for currencies, commodity prices, interest rates and risk premiums.
Make no mistake, the collapse in gold prices is 100% consistent with a reduction in consumption and falling bond yields. This is a natural progression in a reduction in excess liquidity and should not be underestimated for what it portends for the global economic and market cycle.
Over the past couple of months two emerging market experts have been sounding the alarm about the recent currency market volatility and consequences of a strengthening US dollar. Andy Xie and George Magnus are two of the most well-respected authorities on emerging markets, and the recent US dollar rally has no doubt triggered some concerns due to previous cycles of dollar strength.
On February 4 in Caixin Online Singapore based economist Andy Xie, formerly of Morgan Stanley, wrote The Consequences of a Strong Dollar citing a potential crises in emerging markets:
The first dollar bull market in the 1980s triggered the Latin American debt crisis, the second the Asian Financial Crisis. Neither was a coincidence. In a dollar bear market, the liquidity goes into emerging economies, causing their currencies and asset prices to appreciate. The double gains attract more inflow, eventually causing inflation.
These economies lose competitiveness along the way. It is not noticed when asset appreciation supports domestic demand. When the dollar changes direction, so does liquidity. The virtuous cycle on the way up becomes a vicious one on the way down. The emerging economies already suffer inflation. The liquidity outflow leads to currency depreciation, which worsens inflation.
During a prolonged dollar bear market, dollar debt tends to rise in emerging economies. The weak dollar decreases the debt service burden, which emboldens the debtors to borrow more. Extrapolation is a recurring phenomenon in financial markets. Hence, over borrowing by emerging economies is inevitable in a dollar bear market.
When the dollar turns strong, the debt burden becomes unsustainable. Hence, no lenders want to roll over the loans anymore. A liquidity crisis ensues. This is what occurred in Latin America in the 1980s and Southeast Asia in the 1990s.
On February 25 in FT's Alphaville Blog David Keohane posted some comments from a report by economist George Magnus advisor to UBS.
Perhaps the most confident conclusion is that the upshot of these developments [slowing growth, credit expansion and Chinese growth and a stronger US dollar] should see a puncturing of the commodity cycle, at least as far as industrials and metals are concerned. This might prove to be a blessing for most emerging markets, since the majority are net oil and commodity importers. But as and when this happens, the source of weakness will have to be identified carefully. Lower commodity prices resulting from a rise in the US dollar alone might be welcome. But a strong US dollar, based on higher US real interests, and perhaps also reflecting concern about the shift in China's economic model and performance, would be a different matter.
On March 18 Mangus himself wrote an article in the FT titled Rising Dollar Marks Big Investment Shift:
The contrasting economic and financial conditions of the US vis-a-vis Japan and Europe could not be starker. The US dollar should be expected to trend higher against most leading currencies, and put industrial commodities and emerging market currencies and local debt under pressure.
Clearly the yen's rapid depreciation in response to the Bank of Japan's turbo-charged easing policy has been behind dollar strength and overall currency volatility, but this is just one side of the story, and simply looking at the dollar strength as a function of yen weakness ignores the much bigger implications for market prices.
In 2007 hedge fund Corriente Advisors headed by Mark Hart was preparing for their new strategy, the European Divergence Fund which was the first fund that had identified what we now know as the European debt crisis. The fund was positioned to profit from spread widening (divergence) of southern Europe sovereign interest rates to Germany. One piece of the thesis was predicated on excess US dollar reserves exported to Asia that ultimately found their way into investments in European sovereigns. They had noted that historically USD FX reserves tended to get deposited back at the Fed by foreign central banks but that in early 2007 as reserves continued to grow Fed custody holdings began to decline:
One possible explanation is that market participants are borrowing US$ heavily and buying assets in other countries around the world on the premise that the US$ can only fall. One such asset has been, we believe, EMU government bonds.
JPYUSD Vs. Gold Over Percent of USD FX Reserves Deposited at the Fed
During the last dollar bull market in 1996 there were $760 billion in USD foreign exchange reserves representing 9.5% of nominal GDP of which 80% were held in custodial accounts at the Federal Reserve. As the economy grew in the late '90s USD FX reserves remained fairly constant at 9.5-10.0% of NGDP and the dollar strengthened. Only 65% of reserves were parked at the Fed where they remained through 2001.
Beginning in 2002 there was a notable rise in USD reserves relative to NGDP and these excess reserves found their way back into Fed coffers. You will recall in 2002 the Fed was still in the midst of a historic easing campaign and Alan Greenspan had decided to keep the funds rate below the rate of inflation, producing an extended period of negative interest rates through 2005. By the end of 2006 USD reserves were $2.17 trillion rising by a whopping 58% over the 2002 level and now represented 16% of NGDP with 80% of those reserves being deposited at the Fed.
In 2008 the Fed increased the size of their balance sheet by 150% from $900 billion to $2.3 trillion, and by the end of 2009 USD reserves rose to $2.8 trillion now representing 20% of NGDP with 98% of these reserves parked at the Fed. This massive increase in dollars, both outright and as a percentage of the economy, saw the value of the US dollar depreciate by 37% against the Japanese yen from 2002 to 2009 while the price of gold rallied 260%.
Since 2009 the Fed has obviously kept its foot on the accelerator with QE II, Operation Twist (balance sheet neutral), and now QE III increasing the size of their balance sheet by another 45% to $3.3 trillion at last count. USD FX reserves have also continued to climb reaching $3.7 trillion now representing 24% of NGDP from just 10% a decade ago. However you will notice that since the 2009 peak the share reserves getting deposited back at the Fed has been in decline with a steep drop beginning in August 2011. This is a major change in trend from has been in place over the past decade that indicative of a capital flow reallocation.
Just as Corriente suspected the 2007 dip reserves held at the Fed was a carry trade into European sovereigns I believe this larger reduction custody holdings is indicative of a similar short USD carry trade into emerging markets.
Consider that at the August 9 2011 FOMC meeting the Fed replaced exceptionally low levels for the federal funds rate for an extended period through mid-2013. A few months later at the January 25 meeting they extended the rate guidance to at least through late 2014 only to extend it once again in September to at least through mid-2015. This type of calendar guidance for the length of a zero percent interest rate is a dream for a leveraged carry trade. You know your exact cost of funding for a specified time period, and due to this policy, the price of the funding currency will remain depressed. What can go wrong?
The Bank of Japan QE assault on the value of the yen has been well documented, and I don't want to dismiss this as a major influence on the strength in the USDJPY, but I think some attention should be paid to the actions of the Federal Reserve. In December only a few months after the Fed extended the guidance to mid-2015 they removed the date and replaced it with a specific 6.5% level in the unemployment rate. This is a very important distinction from the carry trade perspective because now you no longer have a predictable expiration on your position but instead are at the mercy of the unpredictable economic data. At the same time you have Fed rhetoric discussing tapering purchases in order to reduce the growth of the balance which is also net dollar positive. What was once a no-brainer dream trade has now become a very complex and volatile nightmare.
I suspected this was a major risk, and on January 7 in Is US Growth Blowing Out or the QE Carry Trade Blowing Up? I faded the consensus interpretation of rising bond yields and stock prices:
The correlation between the USDJPY and US interest rates can be seen as a proxy for the larger QE short US dollar asset correlation trade. It's quite possible that bond yields and the dollar aren't rising due to an acceleration of growth but rather because the Bank of Japan is blowing up the Fed's QE carry trade. As happened in 2007, when the S&P 500 made a new high as the mother of all credit bubble carry trades was imploding underneath, it may be the case today that investors are again misinterpreting the price action of a blow-off in the mother of all short squeezes in stocks while the QE carry trade blows up underneath.
So here we are at a critical juncture. Both bond yields and stocks appear to breaking out, but it is not clear what is driving the price action. Is this a product of US growth accelerating or a QE short USD carry trade that is unwinding? It's still not clear, and neither side has an edge. It will be very difficult to position for the move, likely breeding an environment of increased volatility. The market is not going to make this easy on anyone, but if you are patient, stick to your discipline, and, as I said last week, leave your bias at the door, the market should begin to provide more answers as we progress through the ensuing months.
This is what is happening. In the backdrop of a US consumption bubble collapse, the dollar is rallying, gold is falling, and real interest rates are rising while nominal rates are falling.
Due to Fed policy over the past decade, market prices have been the function of a bunch of USD short carry trades that on the surface look very complex. These trades come in many forms including emerging market bonds, multinational stocks, gold, TIPS, and farm land. Whether short the dollar explicitly through leverage or implicitly through exposure, the risk is the same and very simple to analyze.
The initial reaction to the yen collapse has been an explosive rally in risk assets. As the smoke clears we are starting to witness the true macro effects of dollar strength with falling nominal yields, rising real yields, and collapsing commodity prices. This is exactly type of price action you would expect if the great short USD carry trade was unwinding, and I don't think investors currently appreciate the significance of what that means or how ugly it could get.