See the latest Australian dollar analysis here:
Nordea with the note. I can only agree:
The Fed spent most of the June meeting debating a stand repo facility for both domestic and Foreign International Monetary Authorities (FIMAs). Such a facility will be designed to safe-guard the cap of the rates corridor, which is currently NOT what the Fed is struggling with. The debate is hence a reminiscence of the September-2019 liquidity scarcity scenario, while the current response to the liquidity abundancy scenario is much more urgent.
The recent short-squeeze in bonds is not just driven by the transitionistas winning the market narrative, but also by liquidity technicalities and convexity hedging. When the Fed hints of an upcoming taper decision, it leads to weaker anticipated nominal growth down the line and accordingly weaker inflation expectations. When this is paired with the surging usage of the reverse repos (both the ON RRP and the FIMA RRP), it risks creating a negative liquidity feedback loop.
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Chart 1. When reverse repos increase in size, 10yr bond yields tend to drop
Foreign International Monetary Authorities hold an increasing incentive to use the reverse repo facility when the curve is flattening as USD reserves increase in relative value to the bond collateral. This in turn risks accelerating the liquidity withdrawal with further curve flattening as a consequence. A negative liquidity feedback loop.
When the curve is inverted (as in 2019), then all FIMAs hold a huge incentive to maximize the usage of the RRP facility. This in turn also creates an environment when bonds perform versus the swap curve. In other words, keep curve flatteners intact and buy bonds asset swapped in the current environment.
Chart 2. Bonds perform versus the swap-curve when liquidity tightens
A tighter USD liquidity outlook and a flattening USD curve is usually a relatively positive scenario for USD spot after a time-lag, and the DXY index also shows a decent correlation with the usage of reverse repos.
The line of events is probably the following. The Fed tapering means that US Treasury issuance will again outpace QE purchases, leading to tighter financial conditions in Emerging Markets (as USD funding access tightens). This in turn leads to a worsening of medium-term expectations for nominal growth and inflation in developed markets, which is usually a positive USD scenario with a time-lag. All of this is potentially accelerated by the negative liquidity feedback loop that we debated earlier.
Then we haven’t even debated the potential global tax deal, which in our view will prove to be USA bullish due to tightening relative taxation between e.g. the US and Ireland even despite a corporate tax hike by the Biden administration. Another potential USD positive? We don’t put a lot of emphasis on the potential US budget stand-off, and note that it has only happened a few times in history that a uniform congress has not passed a debt ceiling increase ahead of deadline.
Chart 3. USD to gain from a surging usage of reverse repos?
A strong USD is probably the last thing that risk assets need right now, and it wouldn’t surprise us to see a much wobblier risk asset development over summer. We did this simple sketch of QE versus QT flows in various asset classes. When QE runs hot, it simply forces private investors further out the risk curve, while a liquidity withdrawal (either via QT or a surging usage of RRPs) leads money inwards on the risk curve again.
When liquidity dwindles, the riskiest EM markets are hit first, why you should prepare for one or more blowouts in EM-space over the coming months. Second, the small-cap space starts underperforming the large-cap space. We also see the early signs of such a development already. Third, risk assets generally start performing weaker. We are not there yet, but we are getting there.
Chart 4. A sketch of QE and QT flows
It may sound a tad premature to debate liquidity withdrawals already now, but we know that fast-money players try to outsmart peers via front-running liquidity developments by now. 5s30s steepened all the way until the actual tapering started in 2013/2014, while the markets have started flattening 5s30s already when the Fed admitted to debating a tapering process this time around. Risk markets may hence (over)react on the possibility of an outright liquidity withdrawal much sooner in this process as well.
Chart 5. The curve flattening has started even before tapering is actually launched..
Morgan Stanley agrees:
We cast our vote for a stronger dollar and weaker EM assets. We continue to hold a bearish view on EMFX and credit. The trajectory of USD remains higher, in our view, with a shift into neat the Fed combined with strong data amid limited positioning tilting the risks in the direction of dollar strength. At the same time, COVID-19 risks for EM remain high, with the Delta variant circulating amid relatively low vaccination rates. The impact of the latter is clear in the growing restrictions in EM and the recent softness in PMI data.
Sovereign credit–an SDR refresher: Investors have pushed back against tour bearish view, citing benefits of upcoming SDR allocations. We don’t disagree and argue to take risk off only gradually. In terms of beneficiaries, Pakistan, Jordan, Ukraine, Ecuador and El Salvador standout whereas improved liquidity may reduce the urgency to tie up IMF financing in the case of Argentina and Sri Lanka. We also think one should just be focused on how countries use the initial allocation rather than a potential reallocation.
Finding opportunities in credit: We look at fiscal consolidation trends in LatAm, where Argentina, Brazil, CostaRica, DominicanRepublic and Ecuador are doing well whereas Chile, Panama and Colombia are lagging. With Colombia now cheaper and HY, were move our dislike and turn neutral, but look for further weakness to turn bullish. In EMEA, we still like hydrocarbon exporters and focus on Qatar and Oman, where we see further upside on the back of ongoing fiscal consolidation and as supply risk abates. In Asia, we look at SriLanka, where we argue that tying up liquidity facilities is helpful but not a game-changer and investors should focus on adding risk in the belly rather than front end.
If EM junk breaks lower then DM equity will follow and the US dollar rise even more on the safe haven bid.
Finally, Goldman notes that the market remains unbalanced short USD:
In the weekending July6, non-commercial traders net purchased $2.4bn USD following net purchases of $2.1bn USD in the previous week. The flows appear to have been driven by asset managers, as leveraged funds bet sold Dollars. Traders net sold EUR, AUD, CAD, NZD, CHF, MXN, and RUB. They also net purchased GBP and JPY. Asset managers continued to net purchase Dollars over the week, against net sales of EUR, JPY, GBP, AUD, CAD, CHF, and NZD. They also net purchased a small amount of RUB. Leveraged funds resumed net USD sales, against net purchases of JPY, GBP, NZD, CAD, and CHF. They also net sold EUR.
Also bullish USD.