The Fed has been befuddled by two key things thus far in 2017. First, as they outright mentioned in their June minutes, why are FCI's loosening despite 75bps in policy tightening since December? "According to some measures, financial conditions had eased even as the Committee reduced policy accommodation and market participants continued to expect further steps to tighten monetary policy." The other concern, which has largely been expressed by Bullard is, if LSAPs reduced longer term rates, why is term premia also coming out of the curve in this tightening cycle which should encapsulate expectations of SOMA changes? The latter seems to be largely inflation driven, especially as duration has no fear the Phillips curve is about to make a late 60's type surge in slope. However, for this post, I am going to focus on the first question bothering the Fed. As I tried to explain last post, In my opinion, FCI's loosened as dollar liquidity became more available, but that does not mean policy rates have not tightened credit. Liquidity and credit are not the same.
Credit vs Liquidity
Global credit has been slowing for some time (PIMCO)
Global credit impulse has been falling for almost a year now, with China obviously making a large contribution. So while G4 QE continues to have a very meaningful effect on liquidity, credit is slowing and quite rapidly.
Same thing in the U.S., Fed hikes in'17 have exacerbated the slowing trend
If we look at traditional credit channels in the US from commercial banks, they have been in contraction on a YoY basis for some time. What is clearly evident is, the rate of change in the slowdown has gone up significantly this year, as the Fed's tightening path has advanced, 75bps since December. Of course there is a demand side to this equation, and as corporate leverage is quite high, it makes sense for credit demand to slow as the Fed moves rates higher. However, on balance, the Fed's tightening cycle is clearly impacting credit growth and the money supply, which have respectively worsened so far in 2017. In a sense, the economy is tightening, while financial liquidity is not. So the Fed is either prioritizing FCI's over this clear contraction in credit and inflation or they are ignoring the effects of their tightening. One of my mentors, who has been dead on with Fed policy this year, said it best: in their view, they are removing accommodation not tightening policy. Rates are approaching r* and credit is clearly tightening, yet the Fed is wondering why this tightening cycle is not "working"....... The yield curve conveys this message.
The Confusion is in Dollar Liquidity
The recent effort to prioritize FCI seems to have been fostered by Dudley. In his most recent speech at the BIS he said, "when financial conditions ease - as has been the case recently - this can provide additional impetus for the decision to continue to remove monetary policy accommodation." This sort of language either argues for persistence in tightening policy rates or playing catch up. The Fed is not happy with current equity valuations, but they see the bigger picture, cross asset vol suppression should not be occurring as the Fed tightens. Thus, for Dudley, it looks Fed policy needs to shift into neutralizing this liquidity wave. In my opinion, the Fed now believes the the culprits are either G4 QE or the prospects of regulatory reform in the US for banks. This has begun to manifest itself in the past few weeks, especially in CB rhetoric. One week after the Treasury report on deregulation was published that suggested bank balance sheets could expand by the trillions, we saw "coordinated tightening" or "QT" from core CB's. From the Fed's perspective, a more "coordinated" global front hits both of these perceived culprits. First, rates across the curve have to reprice timing of less G4 QE, as ECB rhetoric seemingly has more duration beta than Fed hikes do. Second it makes the market price in less QE liquidity spill over across asset classes, in theory bolstering vol. While these factors are likely contributors to this liquidity surge we have seen this year, to me, it still seems largely Treasury driven and the lack of Tbill issuance which should normalize post debt ceiling.
Growth in CP has coincided with sizable rally in Asian currencies
As I stressed in my last post, where I attempted to go into some of the intricacies of the current dollar liquidity paradigm, this correlation/move epitomizes the plethora of dollars the market has been hit by since the Treasury's debt ceiling move in December. The interrelation of Asia FX and CP is that banks across the Pacific rely heavily on CP for dollar funding. As Tbill issuance is lower, banks fill the demand by expanding CP issuance, which has very positive spill over effect for risk assets. Last year, the BIS famously pontificated that the dollar is the new VIX, while I think in generality they are correct, the real message seems to be, access to dollar liquidity has a distinct positive relationship with cross asset vol, but especially in FX. My early inclination is, the combination of SOMA changes and more sustained Tbill issuance will reverse this cheap dollar paradigm, which looks already to be topping out. Lets also remember, EM has rebuilt its massive short USD, as dollar denominated issuance has soared in the past year, according to the IIF. All of this despite 3 Fed hikes.......
Asia Dollar Index Breaking its YTD Uptrend?
USD actually offers some asymmetry if the Fed ignores inflation
I am coming to the conclusion that at this juncture USD positions are much less binary in terms of risk profile relative to receivers in core rates. I will attempt to outline this case via a list of scenarios. This is excluding my core thesis with regard to dollar liquidity and the reemergence of a dollar shortage. More traditional FX, flows and rate diffs.
1) Reals argue for higher USD. In effect, my core macro view on the US continues to be the data will underwhelm as the pass through from oil continues to negatively effect inflation and HH spending remains frustratingly weak. As the Fed looks pretty set in dealing with taming the animal spirits and FCI's in markets, real rates should continue to edge higher with inflation slowing. Because of the move in reals, USD can sort of act as a curve flattener without the weak carry+roll the curve is currently giving receivers.
2) In the near term, it is hard for me to envision a macro environment, where the relative CB tightening moves into other G8 players. The market has priced a lot more absolute hikes in aggregate for developed market CB's in the past few weeks. To me, while it seems possible the BOE and BOC, could hike rates this year (why, beats me) any environment that allows them to put 25 bps back in o/n rates, is an environment which the Fed can fulfill their dots. And to me, we have gotten a bit aggressive in thinking how hawkish some of these CB's will be, Im lookin at you Poloz and Wilkins..... There is also a high likelihood of a reversal in policy rhetoric in these countries, which is USD positive.
CAD curve gone wild, 6m1y. Receiving kind of tempting, C&R is decent too.
3) USD would also benefit in a return of the Trump trade. Given how low U3 is, the Fed will be aggressive in rates if Trump is actually able to get something stimulative passed. The Fed is worried since U3 is so low and the inflation derivative has not arisen from higher wages, that it may come in a non linear fashion (think this is weighing on them currently, hence them moving ex ante to Kashkari's chagrin). USD should work in an environment in which either the econ is boosted by Trump or the Fed moves OIS curve closer to their dots like in December of 2016. This to me is the relative asymmetry of the trade which protects me in case macro is wrong.
Has the economy been fixed since CB's went hawkish, guess not
US5s30s kinda close
Thanks for reading, happy summer.
Jonathan Turek
Nice piece.. Usually I would fade someone who thinks like me, but lower green/blue Eurodollars and Short-sterling rates back up the lower for longer hypothesis.
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