America First killing global liquidity?

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MB Radio: Irresponsibility becomes the new black

Via GaveKal:

Regular readers will know that among the key influences on global markets is what I call “international liquidity,” which I have long monitored using an item on the US Federal Reserve’s balance sheet labeled “securities held in custody for foreign official and international accounts.”

This barbaric wording refers to the US dollar foreign reserves of other countries, largely invested in US treasuries, which are held in custody by the Fed on behalf of non-US central banks. With the possible exception of gold, which is relatively illiquid, holding US treasuries at the Fed is about the safest investment a central bank can make, since both the assets and the custodian are as reliable as you can get.

As well as being the safest form of reserves, these are also the most visible, and so are invariably the last to be sold. In consequence, in the past a year-onyear decline in this indicator has generally meant that a big country or group of countries was starting to have problems. This has seldom been good news.

The chart below shows the data series deflated by the total return on treasuries to exclude the growth of reserves generated by interest payments and capital gains, in order to focus on the underlying growth of the monetary aggregate.

International liquidity crisis indicator

As you can see, every time these adjusted reserves have registered a year-onyear decline, the fall signaled what I call an “international liquidity crisis.”

And every one of these international liquidity crises since the early 1970s led in short order to a black swan-type event in financial markets.

• The only black swan that was not preceded by a year-on-year decline in this particular monetary aggregate was the financial crash of 2008-09. That was not caused by an international liquidity crisis, but by the sheer incompetence of Hank Paulson and Ben Bernanke, who decided to let Lehman Brothers go bankrupt—an utterly unbelievable error.
• Otherwise, all the black swan events took place during or following an international liquidity crisis. These events usually precipitated major firefighting moves from the Fed or other central banks (the Bank of Japan in 1985, the European Central Bank in 2012, the People’s Bank of China in 2015). And as often as not, one or more sovereigns ended up going under (Latin America in the early 1980s, Asia and Russia in the late 1990s, Greece in 2012).
• These black swan events had two common characteristics. Firstly, the US dollar went up (with one exception: 1988-1992, during which the US dollar’s exchange rate was flat while real interest rates in Germany rose to 7% following reunification). This makes sense, since an international liquidity crisis is a sign that there are not enough dollars circulating outside the US. Secondly, the US stock market outperformed non-US stock markets. Again this makes sense, since an international liquidity crisis is caused by a shortage of dollars outside the US, which is seldom good news for non-US markets.

Since late 2018, assets held by the Fed on behalf of other central banks have again been declining in year-on-year terms, with the value down -14.8% at the end of September 2019. It should therefore be small surprise that stock markets crashed in the last few months of 2018.

To stop the rot the Fed did a huge policy U-turn, first by signaling it would stop interest rate increases, before beginning to cut rates, and second by halting its balance sheet contraction and beginning once again to expand its balance sheet in a program of “just don’t call it quantitative easing”

The markets duly rebounded.

Liquidity perplexity

This is where things get interesting. Financial markets have reacted as they always have in the past when the Fed or other big central banks cut rates and started to print money. In the past, similar moves usually led pretty quickly to a recovery in the growth rate of central bank reserves held at the Fed, with the newly-created dollars appearing abroad almost immediately. But not this time. Foreign exchange reserves are still falling; and the fall appears to be accelerating. This is perplexing.

Conclusion

The world faces the risks of an international liquidity crisis. But nothing is preordained. The world can escape this dangerous period if the reserves of foreign central banks deposited at the Fed start to grow again. For that to happen, the private sector players who over the years have earned the US dollars pumped abroad by the US current account deficit will have to go back to converting more of those dollars into their domestic currencies by selling them to local central banks. This in turn implies an appreciation of local currencies against the US dollar, and a decline in long term interest rates in these countries. The only place where this is likely to happen is in Asia.

If this is correct, in the not too distant future Asia could enter into a deflationary boom, going through a triple merit scenario, in which:
• Currencies appreciate
• Long term interest rates fall
• Long duration assets, such as growth stocks and real estate, go up

I wonder if the answe isn’t pretty simple. America First drains global USD liqudity on several fronts:

  • tarrifs drain US export revenues of mercatilist states so there are less USD’s in the system;
  • central banks seek to diversify their reserves;
  • both mean US growth and inflation out-perform, putting a broader bid into the USD.

You can’t decouple the US and China without breaking a few eggs and one them is global USD liquidity.

David Llewellyn-Smith
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