Jackson Hole

As we head into one of the key macro/central bank periods of the year, I thought I would share a few thoughts with regard to policy changes and expectations. I think it is very interesting that we are entering a time where the ECB will discuss the evolution of their sprawling easing program, the Fed will be beginning to unwind their balance sheet after the September meeting, and vol in rates is on the floor. Another important aspect of this jigsaw is the knock on effects of these two events. With regard to the ECB, how does the BoE, Riksbank and SNB respond if Draghi outlines a withdrawal of monetary easing in October? As a whole, the dichotomy between perceived event risk and market pricing is large, which means macro could be pretty interesting going into year end. As a side, the black and white charts of my previous post, are dead! Instead, I overcame my laziness and put speciality charts, such as workbench, into excel. Long live clear charts.

Jackson Hole and ECB Going Forward

Instead of giving trade ideas for Friday specifically, I want to look at the broader picture and try and discern what are the ECB's practical options as QE inevitably takes on a different form. I believe JH will only be the beginning, as the amount of ECB trial balloons will surely accelerate into October. For context, I have written in the past that the ECB will likely remain persistently dovish this year despite improving data, and that the inevitable transformation of policy will not look like the Fed's playbook from '14. For me, there are two key reasons why this is still the case. First, from Draghi's perspective, the APP (asset purchase program) was of course meant to narrow the massive output gap, but the major policy initiative was a convergence in spreads and to stabilize funding and capital flows for the periphery. As I wrote before the French election where I advocated buying BTPs, budget deficits have come in, but PSPP (public sector purchase program) has covered most of the cracks. Spain can run a -5.5% budget deficit and borrow 10y money at 1.6, Italy can fund itself at bunds +180, only in this paradigm does "austerity" become a bit more tolerable, if existent at all. This is why the ECB "taper" will not look that similar to the Fed's; the delicate balance of measuring how much withdrawal the perif can take with an upswing in economic activity will lead Draghi to be a bit more creative in his final two years. I am aware that the current ECB statement language indicates a more traditional policy path, i.e. similar to Fed playbook, but I think going into the October meeting the market will have to adjust certain probabilities in rates across the curve and by effect in FX. I want to avoid such binary terms such as "hawkish" and "dovish" as I think these two terms overlook the significant nuance and complication that will go into Draghi's exit plan. My pontification is that the current perception of the ECB exit sequencing is wrong, but does pulling the front end less negative instead of steepening the curve through taper, constitute as "hawkish", my feeling is not.

With that background in hand, Long 100.125P in ERM8, and short bobls, OEZ7 with a -40bp stop. (I've seen an interesting put fly but would love see other interesting convex structures). What I like about this thesis is, it will only take a famous ECB trial balloon for it to pay off, even if the Fed '14 model is the ECB what practically takes place. Now, this idea in theory contradicts with my core theme of this year, persistent ECB dovishness on the basis of keeping periphery spreads super tight. In essence it does, but the fundamentals of this trade expression convey certain assumptions that I want to explore as they are likely being underestimated by the market. And, these two trades provide a very convex outlet for a multitude of these variables being assigned a greater probability by the market in the coming months.

There are three likely scenarios in my view:

Option 1) Hike instead of taper. In Q1 of next year, a 10 bp DFR (depo rate) hike could come to soften the blow to buba of a dovish APP reduction to 40B a month for 2018. OIS out until April of next year has less than 10% chance of rate move. Again, despite the current ECB statement, I think Draghi may look at pushing EONIA closer to zero as a way to keep his periphery spreads project alive and well and appease German hawks. If anything, pushing up STIRs in Euroland could prove to actually be quite stimulative, as the banking sector would certainly welcome it with loan growth already picking up over 2% in '17. Due to scarcity concerns, Draghi at the current rate of purchases can likely get to around June, so take APP down slightly to keep program for most of '18 at a minimum. In this quid pro quo, hawks at the buba get a hike and Draghi continues to fund periphery budget deficits, albeit at a bit of smaller pace. The fact is, from Mario's perspective, APP works while NIRP reviews are a mixed bag, why not keep the more effective policy tool going? Draghi can push EONIA on path back to zero as a much healthier form of tightening relative to making significant changes to APP. A switch in the exit sequencing looks to me as much easier way out for Draghi, and the market is not pricing it, 4bps in ERZ7-M8.

ERM8 100.125P, vol in reds is super cheap



Option 2) Draghi has made it clear to markets that only one thing matters: "Our mandate is neither growth nor employment, but price stability." Would it surprise me if Draghi says screw you to the buba, core HICP inflation at 1.2 is not high enough, and considering recent EUR move weighing on 5y5y inflation swaps, he could have a case that to get inflation to mandate, the current state of mon pol is still appropriate. Draghi can also say, Chinese credit growth is likely to slow next year, Euro econ runs on a lag to CH expansion, do I want to be withdrawing stimulus into that? Very easy to see how Draghi takes the most dovish way out, especially if pressures from German election do not really mount and inflation begins to roll.

Biggest risk to ECB exit trades, China



In prior posts I have looked at Chinese imports from Germany as a leading gauge for HICP inflation, and it has largely played out so far this year. However, I think this chart better encapsulates the lag from Chinese credit expansion onto German HICP inflation. Despite three year highs in copper and a pickup in the credit impulse, I still remain skeptical of the durability of the current expansion in China. The rally in industrial metals looks to be more driven by WMP issuance and inflows, as domestic stocks remain very elevated. However, if German inflation is operating on a few month lag to Chinese credit expansion, prices could still slow over the coming months, which gives Mario an easy way out and bunds trade back into the teens. This is likely the biggest non geo-political risk to the trade, but one can easily say, Mario will be too late to notice and the German pressure will force action. The beta of Euro rates to Chinese industrial expansion cannot be underestimated, so to counter maybe add a receive AUD leg onto the trade to better hedge out CH risk? This sort of deflationary risk also speaks to raising rates being advantageous over taper. If Draghi hikes DFR 10 or even 20 bps, he can easily stop if deflationary risks from China or oil are to reemerge. With taper, the Fed model suggests some sort of monthly auto pilot is most ideal, as big monthly deviations will cause increased vol in rates land. Another thing for Mario to factor in if he is skeptical of current upswing as Trichet's shadow hangs.

The other side of the Chinese Coin



So, if Chinese credit impulse indicates that HICP inflation in Germany should fall, the rise in the RMB suggests the exact opposite. To me, this is a powerful chart because as I have talked about, persistent weakness in the USD is a powerful global stimulant. I am sympathetic to the view that dollar scarcity will reemerge following a normalization in bill issuance, but if until then, the debt ceiling and persistently low inflation in the States keeps the dollar on the offer, that weak USD stimulant will be alive and well. Lots to balance here, especially when Chinese fundamentals have proved so difficult to properly judge as individual variables, let alone systematically.

Option 3) More consensus exit sequencing. Draghi likely extends QE slightly into 2018 but lays out plan of eventual path to 0, obviously not including reinvestments. Draghi acknowledges output gap is narrowing, inflation forecasts for 2018 rise slightly, and DFR hike first or second quarter '19. The biggest pull to move Draghi in this direction will not be economic, as I have tried to emphasize, to Mario's credit, he is a big picture guy, cyclical upticks will not shake him off his systematic and structural goals. Scarcity is the real problem for the QE forever camp, unless much bigger capital key deviations are tolerated, which is tough to envision, QE parameters will have to change. German WAM is slightly above its lows, but still down to near 5. In this case, Draghi is forced to lay out plan in many stages to begin taking monthly purchases to zero, as QE reaches its natural limit.

5y Bobls v 1y1y EONIA 



In theory, given my thesis, paying rates on 2y schatz should be a better trade expression. The reason I prefer bobls is its flexibility to different scenarios. In my base case, ECB talks market into pricing in a DFR move more quickly and pushes off significant taper talk, can bobls still trade inside a rising 1y1y EONIA? The generality is, if the ECB can ever so slowly push EONIA closer to 0, bobls would have to follow suit. In case two, Draghi stubbornly continues APP close to its current form for most of 2018, I don't think bobls can trade inside depo again, especially given the pickup in domestic economic activity and HICP inflation. This is really sort of the obvious asymmetry, unless Draghi expands QE, I do not see bobls trading at a real rate of -200 bps. The other point is, if Draghi goes full out dove, he kills EUR before German current account can effectively adjust to trade weighted strength, this would in essence shoot higher inflation expectations and likely prevent a persistent rally in the belly out. Case three is likely the most self explanatory. Threats of more traditional exit sequence will crush the overbought belly of the German curve, look how bobls sold off following Sintra. The latter case, despite being third on my list of probabilistic outcomes, shows why the bobl short is more advantageous to schatz, as it has more beta the Fed model of taper.

EU GDP v Expected Real 5y Bobl (reals are a nebulous concept to me, but I used 5y5y swaps here)



Draghi and Inflation

Part of the reason I think the street and even ECB rhetoric has the exit sequencing wrong is because of inflation. Yes, inflation has accelerated meaningfully this year, even Euro super core inflation is picking up. However, in Draghi's "hawkish" Sintra speech he effectively told us real rates have to be zero. So while core HICP inflation has made progress at 1.2, does it really satisfy, "the close to but below 2%" mandate, maybe for Weidemann but not for Draghi. So inflation still needs to pickup and this move in EUR is not helping. The question is, if Draghi needs an outlet to appease the Germans, why does moving EONIA closer to zero have less of a negative inflationary impact than tapering? The answer may lie in a working paper from the ECB, which was released in June (http://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp.2075.en.pdf). The paper goes over a VAR based model which estimates the impact of APP on inflation and real GDP.  The paper did not compare APP effects and impacts as opposed to using overnight rates, especially past the zero bound, but rather the models results are interesting with regard to the timing of inflationary impact. In effect the model attempted to quantify the lag through in the different transmission mechanisms, lending, FX, etc. What we learn is, there is a much higher higher residual time variance for inflation as opposed to real GDP. This means, by tapering, Draghi will risk messing with the positive lagged effects of the APP, especially on inflation, as they are still making there way through the system, even if some have peaked (VAR model suggests based off APP changes in '15, Q4 2016 and a 0.36% impact is the peak effect). Considering the general negatives we have seen with NIRP, it makes a lot of sense to me that taking the front end less negative will not have as big of an effect on inflation, as the bank lending transmission onto broader loan growth will likely be more positive. Can Draghi appease the buba and at the same time actually keep this uptrend in inflation, just may be, moving EONIA closer to 0 instead of big APP changes is that outlet.

EUR 5Y Forwards, Maybe let EUR do the Work?



In my opinion, Draghi's concern with the recent EUR may be a bit overstated, especially as it is everyones base case for a dovish JH speech. Yes, effects of rising trade weighted EUR negatively impacts growth and inflation, but, it disproportionately hurts German econ. We have already begun to see this in German survey data, PMI and ZEW starting to come in from very elevated levels, but also in the German stock market. Remember, since EMU inception, Germany has kinda taken current account surplus from others in the bloc to make their own monstrous surplus +8% of GDP. The contrarian in me says, well, Draghi is in a place where his priorities are systematic in nature (tighter perif spreads), and the biggest threat to him having to remove those safety measures is, German economic expansion.... The variable with the most beta to restoring some balance among the EU economies, i.e. leveling out German growth with an adjustment to current account, may be a slightly stronger Euro. Sure, Euro has effectively tightened some financial conditions in the EU, but the core effects look largely Germany bound, which actually prevents Draghi from having to rush on mon pol changes in the name of quieting the German hawks. In an Ideal world, Draghi knows relative weakness in EUR is a large boost to inflation expectations and trade across Euro Area, but at current levels it may actually smooth out some of the disparities in the continents relative growth rates.

Regime change in relative curves, German v US 2s10s



Something I've noticed over the past few months is that the US-German 10s spread trades tighter than the respective 2s spread. If you look at this series over more significant time frame, you will see this has not been the case for over five years. This paradigm shift does make sense given consensus outlook for the ECB and Fed respectively. Inflation in the US is rolling over and the ECB is about to taper, so 10s spread should tighten, which likely every macro HF has on given its positive c&r. With regard to 2s, yes, the Fed is towards end of hiking cycle but there is no way the ECB goes at rates before Fed is done, so 2s still trade super wide. I want challenge both of these assumptions and even suggest that with Fed SOMA changes to begin in October, this paradigm can revert back to its recent norm. In my mind the narrowing of schatz and US 2Y makes a lot more sense in my ECB framework than narrowing in the belly and out. Fed will be making conscious effort to turn duration lower for the sake of tighter financial conditions, while the ECB may go out of their way to keep duration, especially in perif, bid. On the flip side, the Fed is getting to the end of their tightening rope in o/n rates, while the ECB could be just beginning..... Short schatz long US 2s also works, especially given spec shorts in US 2s, or trade below.

ERZ7-M8 v EDZ7-M8, 9.5 bps

Fed Tightening Cycle has been more "Normal" than you think



While one wouldn't think it, on a relative basis, this tightening cycle has been pretty "normal" for a post Volcker cycle. In shadow rates (Wu-Xia above), you're at over 300 bps of tightening for this cycle if the Fed goes again in Dec, in my opinion a bigger than 40% chance. Also, if you asked the Fed at last year's JH, not sure Fischer would have told you the odds would be high that by year end '17 we would be this close to in policy rate to r*. However, given the calcs and weightings of prior months, inflation on YoY basis is stuck. The Fed has already tried to hedge future CPI readings by saying they will focus on sequential readings instead. Of course it is hard to say what the Fed path will be if Janet is replaced by Cohn in Feb of next year, which has contributed to the shallow path in reds, greens and golds, but with core PCE stuck near 1.5 and bank lending contracting, the writing is on the wall. This does not even take into account if SOMA changes begin to go awry in 2018, a very real possibility that the Fed and market is discounting in the name of a steeper curve and tighter financial conditions. But in my view, the latter will be taken care of by a normalization in Treasury issuance.

14bps, US 2s and Effective Fed Funds, Unless r* Moves Higher, the End is Near



US 2s inability to really sell off since Jan has been very telling. My thinking a few months ago was, this is the most obvious r/r short, 2s trade 5 bps outside IOER, 14 bps from effective Fed Funds, and they have great optionality on Fed surprising market with more hikes. It turns out I was not alone. People like to talk about market messages to the Fed, like, "what does it say that despite 3 hikes since the election and spoos are still at ATH's". My answer would be, look at the curve. 1s2s like 8 bps, and the 2s are about to invert with with o/n rates if the Fed goes again in Dec. This is either a massive mis-pricing or the curve is sending a message. I bet the latter and am emboldened by the fact positioning is so heavily skewed to the other side. I would say, going into JH this position is less appealing to me as Yellen could use Jackson Hole to remind the market who is in charge, but as a whole, I expect a big narrowing of US 2s German 2Y schatz spread.

Interesting dynamic between Fed and ECB could start in JH. 

In the spirit of Jackson Hole game theory, it is fitting to end this post on something a little bit out there and not readily practical, but I here it goes anyway.

I think it is well accepted in the CB community that coordinated tightening, if justified, will have to be the name of game, no one is looking for a '94 type move in rates. This is where Draghi must think, when it's time for the process of real ECB normalization to begin, the Fed will have to play ball. It's simple, Draghi is looking at the Fed's expected policy path priced in ED$ and saying, they are nearing the end, especially as inflation has come down significantly the business cycle is very old in dog years (about to be second biggest post war expansion).  Not hard to see, especially if problems arise from SOMA changes, that the Fed could be reversing course over the next 18 months. Well if that's the case, that creates a much cleaner buffer to hawkish policy shifts from the ECB, and in a sense, they did the same thing for the Fed. What happens to duration in USTs after QE is wound down and the Fed outlines dots path to neutral rate of +3 if the ECB doesn't come in and quash term premium? From Mario's perspective, why can't this play out in reverse, i.e. Fed keep some sort of lid on EGB term premium while ECB takes APP to 0.... This is a very out there, but its worth keeping in mind over the next couple of years. Mario could be thinking, its time for Janet to return the benevolence that ECB QE showed the UST curve in '14. Of course this would have massive FX implications that Draghi would want to avoid; it's a work in progress.

Short Sterling Rates still discounting BoE (L U7-M8)



Quickly touching on my BoE thesis from last post, I think it is more in tact than the previous presser would suggest. GBP/CHF long has moved but is basically unched over the month. While Carney's presser was interpreted as dovish, I actually thought he just went over justifications of a hike despite sluggish growth... Spare capacity receding, and if that process is to accelerate, OIS curve has to price in more and sooner hikes. Message from Carney, in my view was, ya economy is sluggish but if ECB moves the needle and EUR/GBP continues to shoot higher, I'll be forced to move. Reason I like pound swissy pair is, SNB in that situation will come out and likely say the opposite, that they are not following as geo-politics have kept CHF too strong this year. I believe I am right in saying that we will not be hearing from Carney at JH, but his deputy, Broadbent will be there, worth keeping an eye. Economy looks weak and FX pass through onto inflation is waning, but if Carney does not keep up, FX driven price instability will return.


Thanks for reading. My email is jonturek@gmail.com, please reach out. Have nice rest of the Summer.


Jonathan Turek

Post July 25

With regard to the layout of the post, there are a few changes. Unfortunately these are not Napoleonic changes to maintain "superiority." At the Greenwich Library, where I get my Bloomberg access, there are some weird issues with regard to saving charts. Some of my speciality charts like in workbench, do not save in color, while normal GP charts do. Despite this lack of uniformity, I hope they are still clear.

Slight pickup in growth, rooted in USD weakness? (Chinese Imports and Asia Dollar Index)

Here is the first example of my black and white workbench chart, to clarify, it is a ten year times series of the ADXY v Chinese imports (YoY). With that said, the USD is good place to start. I have tried to expand on the dollar liquidity paradigm of this year in prior posts, I revert back to that topic and its timing towards the end. What is clear, since June, Chinese aggregate demand (AD), especially for industrial materials, has perked back up. The relentless selling in USD, across almost all major crosses has seemingly led to "reflationary" pickup. Of course following the 2016 Chinese fiscal boom, we know the knock on effects of increased Chinese AD onto G10 econ is quite profound. However, in this case there is a cyclical difference. USD weakness is fostering economic growth, not reacting to it. To me, the former is a much more sustainable paradigm. The problem is, I still see a big dollar move following normalized Tbill (Sept/Oct) issuance that will negatively impair this pickup in economic activity. For now, there are some trades in rates and FX that have lagged this USD move which offer some decent relative value.

Following the surge in Chinese industrial activity in Q3, as rates, commods and PMIs all surged higher, the USD followed. Of course a lot of this had to do with politics and the excitement of legislative changes in Washington. So while the sell side tripped over themselves to assign higher USD targets, they were coupled with an expectation of escape velocity in DM economies. Economic growth that is coupled with a rising dollar is ultimately a self defeating paradigm, especially as the dollar was already at such an elevated level. Now, as YoY rate of change in the BBDXY is near 2014 levels, world trade in USD can pickup and industrial metals can advance. The dollar is reaching a threshold which is becoming a stimulative force.

Pay KRW curve instead of chasing copper? 2s10s (white) v copper (orange)



Case to be made that copper is breaking out on a multiyear chart. I do not feel comfortable with saying that at this time given how volatile Chinese consumption patterns have proved to be in the past few years. However, if copper is moving north, KRW curve should steepen with it, carry and roll in the swaps curve seems to favor steepeners as well.

Korean Econ tracks Chinese industrial demand. (SK GDP v China copper imports YoY)

Considering Korean exposure to China in terms of trade, makes sense for GDP to correlate well to Chinese industrial activity. Again, I am not convinced that China is looking to reengage a 2016 esk fiscal bazooka, especially as policy rates have tightened slightly this year in some medium term lending facilities (MLF). Credit impulse is much weaker and banking worries remain a concern. The weakness in the dollar does mean better terms of trade for the Chinese, who have done some positive things with regard to structural reforms in the industrial sector. For me, being outright long copper is a stretch, but to get more exposure to the perception of better global growth, I would rather use the lag in KRW rates.

Copper (blue) v its curve. Nearby and Cal '18 (Q17U17 and Z7Z8)



This is more evidence of the dollar spillover. In both the nearby spread and the calendar '18 spread, the curve trades fairly steep contango, especially relative to Q4 of last year. Yes, supply disruptions have continued, but the curve is signaling there is plenty of copper. As I said earlier, it seems that dollar has reached a threshold that has unleashed a stimulative knock on across risk assets, especially ones with positive beta to economic growth and China. OBOR talk has clearly accelerated this year, for me, it is still too soon for that variable to justify a big breakout in copper, even though it will likely one day.

US Rates and the USD

For much of the preceding nine months, there was a positive correlation between yields and the dollar. This had a lot to do with the expected Trump boost, but also, as the dollar rises at these relatively high levels, EME's, especially China, have to sell dollars, which has a positive feedback loop for the dollar. Higher USD forces selling in USD denom assets (USTs) which leads to higher rates, and then a higher dollar. One could argue this pattern has largely reversed but to me the reciprocal is less significant, if it exists at all. The key is, rates will have hard time rallying on USD weakness, even if it is rooted in a lack of DC legislation, as the positive global knock on effect of a weaker dollar is budding.

For much of the year I have been die hard with regard to owning duration, especially in the US. However, right now I am painfully neutral on 10s as I could easily envision scenarios where they trade 2.6 or 2 flat. I wrote a piece a couple of months ago about the two competing variables driving yields, especially in the backend. "Flow vs. Data." The argument for me is, on the one hand, inflation is slowing, lending has slowed dramatically, the economic cycle looks old in dog years and the consumer seems exhausted despite high levels of survey confidence. The "flow" side says, the Fed will engage in SOMA changes this year as they are uncomfortable with the shape of the yield curve and the current easing of financial conditions, despite their ongoing hiking cycle. Treasury will have to increase issuance in a big way following the resolution of the debt ceiling, this looks likely to coincide with the early stages of USTs rolling off the Fed's balance sheet. While I continue to believe the ECB will be annoyingly dovish in terms of policy, the parameters of QE will change this year to less accommodation, which means another sucker of term premia will be pulling back. Even if it is small, rates, especially in the belly out, have shown how sensitive they are to Mario being Sintra esk in terms of message. My thinking with Draghi, as it pertains to US yields, even at his most dovish, he could probably only send us back to 2.10ish, but if the buba gets to him, G10 rates as a whole would explode. Despite my frustration with regard to the judging 10s for the next few months, my "flow v data" dichotomy in terms of price does crystalize in this sense. The "data" has largely played out, inflation made the big drop I expected, economic growth has not been as weak as I anticipated in Q1, but still is quite sluggish. On the other side, "flow" could be just beginning..... Hopefully by the time the next post rolls around, I will have a better feel for 10s and 30s.  For now, despite Gundlach's warnings, owning the front end is a better risk reward for me. Despite two hikes, 2s trade around the same level they did in Feb, and now trade 20bps ish tight with effective Fed Funds. The Fed is overdoing it and the bull steepening is about to commence, or a shift to balance sheet is upon us. The Fed has made it clear that o/n rate will be there main expression of monetary policy, but I think the Brainard camp of at least more of a balance sheet preference in the face of falling inflation, will begin to come across in the July statement. There is one thing I know for sure about 2s, a lot of folks are short....... Buy TU's on dips unless FOMC is more explicit about hiking cycle. Also an easy position to hedge in FF's (V7 in FF with only 10% chance of Sept hike) or ED$s, as market has an underwhelming view on Fed path for this year and '18.

CFTC Net Shorts in US 2's



Another example of dollar reaching stimulative threshold, Aussie 10s. 



ACGB's are good bellwether for global growth, given Australia's dependence on Chinese demand. The RBA will likely remain neutral this year in my view, inflation has begun to slow and Lowe doesn't want any part of the A$ trading at 80c. No "coordinated tightening" for Lowe, if anything, he wouldn't mind the Fed doing the lifting for him. While shorts in AUD are tempting, the chart above reinforces this paradigm shift, where USD weakness has fostered weakness in duration. Like USTs, ACGBs traded lower as the dollar drifted higher from Q3 until its peak in January of this year, and as the dollar weakened on weaker growth and political dysfunction, ACGBs rallied. This all sharply changed in June, as this dollar threshold was met and assets with positive econ beta rallied.

GBP and Carney's phobia of pass through

The Pound is one of my fascinations at the moment. While it has been stronger against the USD, against other major crosses, it has been quite weak. It makes sense; domestic data in the UK is poor while every other day there is a headline of a financial firm relocating outside of London. Sterling should be negatively effected by, shockingly low real rates, falling domestic wages, cyclical slowdown in aggregate demand due to high levels of household debt and rising costs, and the prospects of further deterioration in the country's capital imbalance as financial firms relocate. That list does not even include the rapidly deteriorating political economy. Textbook short? Yes, but not yet. In fact, against some crosses, Sterling is a near term buy.  I hope Festinger would be proud of this cognitive dissonance.

The Haldane speech in June was immensely consequential; obviously, gilts sold off 30 bps in 10s. But to me, the significance was not that the Bank seeing it appropriate to pull back their post Brexit easing, but rather there was a shift in priority. Just as the Fed has seemingly shifted from PCE inflation being the priority in justifying mon pol hawkishness to FCI's, the BoE has done the same but by focusing on the EUR/GBP cross instead traditional macro data points. With 40ish percent of their imports from EU countries, weakness in the pound has a profound pass through onto inflation and Carney has noticed. Given this broad Euro rally, which has taken Euro Sterling back to post Brexit levels, I expect the BoE to use rhetoric as a policy tool to keep a floor in Sterling, at least until the Euro stalls out. They are late, but if Carney is in defend GBP mode, at least for now, no reason to stand in his way; despite the plethora of catalysts suggesting weaker Sterling. While inflation is falling and the pass through from Brexit is receding, the BoE will be extra cautious given this magnitude of EUR strength. For now, extra cautious = hawkish.

EUR/GBP v UK PPI Input


GBP/CHF, good expressions of GBP other than long Cable




Going into the July ECB meeting, I liked this from the short side as a relatively asymmetric expression on a less Sintra like Draghi, but also acknowledging the possibility of rates fireworks show. Now, with Jordan's recent comments about CHF strength hitting, shows me SNB is not looking to play in this "coordinated tightening" game either, not even a little! Besides carry, this structure could be the best way to express this GBP thesis, especially since much of it is EUR related. The key to this cross is their common beta to ECB policy risk, i.e. both central banks are expected to lag the ECB in some sense. However, with Jordan and the SNB putting more emphasis on dealing with a CHF they feel is too strong, the better way to jump on the overdone EUR boat, is to be long sterling/swissy. The concept is simple, if the Euro continues to rally, on whatever reason, QE changes, economic growth or increased capital flows, the BoE will be in full chase mode. The SNB on the other hand, will have to come out in the opposite way, talking down CHF. One CB has an annoyingly strong currency while the other has frustratingly weak one, I expect their respective rhetoric to reflect that over the coming months. Pretty cheap to execute and easy stop at 1.225. This will be a great short when Draghi disappoints the Buba and Euro bulls in the fall, but until then, BoE is in Sterling defense mode.

GBP/JPY



Anytime it seems easy to be Yen bearish, is usually the exact time you do not want to be, especially with broader JPY positioning quite short. With this cross, I would let the price action dictate positioning, maybe a knock in at 142? This GBP cross is not as "connected" to the ECB dynamic as the swissy trade is, but it is another example of being long a currency a central bank wants to talk higher vs short one that wants to talk it lower. Over time, I like this trade from the short side, but for now, I expect it to breakout or bounce off this uptrend.

Do relative levels in STIR spreads boost GBP? 



At least in 2018 spreads, short sterling rates trade outside its European peers in euroswissy and euribor rates. While there is a probably a relative value trade here, I do think this signifies something, given the above context. Yes, if the above thesis is true and the BoE is in Sterling defense, short sterling rates should probably track euribor, especially in reds. Despite the weakness in the economy, especially in a relative sense to the broader Euro economies, it's "easy" for Carney to stick 25 bps back in the curve and still say policy is incredibly easy. The larger point here is, Carney has the flexibility to pull a move like the BoC, remove the extra emergency part of QE, i.e. the second part of rate cuts, stick some bps in the OIS curve, and in doing so strengthen the currency. One "misunderstood" Draghi speech in Sintra, and we tantrumed in rates, BoE dealing in a different ballgame.

Paying front end rates, has lagged big EUR moves



Current state of inflation is eating into the economy

Relatively high levels of inflation have left a mark on the UK economy in recent months. Since the end of last year, real wages on a 3m basis have gone negative, with much of the weakness in the "real" aspect. In a sense, the UK economy cannot afford inflation to eat into household incomes as there is a quick pass through into spending and there is very little buffer. This is the case for two unfortunate reasons, first, household debt is over 140% of GDP, so it would be difficult for credit to smooth over the weakness in incomes, second, UK households have already brought forth demand by depleting their savings. So credit and savings cannot save consumption, which means to "stimulate," Carney needs to save real incomes.

UK Real Wages are negative



UK Savings Rate has collapsed



Time to fight Poloz and BoC?

BAZ8/FFZ8 at -28bps (Chat below is spread between the two)



I think this an interesting expression of fading the BoC as it allows for two things to happen. First, it lets the market assess the path of the funds rate after the FOMC starts SOMA changes. Second, it gives the market time to realize the expected BoC rate path is overdone. I already suggested fighting the BoC with 6m1y receiver in CAD rates, given the c&r of the position I would let it play out further. In my view, the loonie ripfest has begun to slowdown, the market could begin to bring down its aggressive BoC path faster than people expect as the pace in which Poloz and Wilkins got hikes in the curve affords the BoC flexibility with timing. Maybe patience is a virtue, especially as inflation came in weaker again in June, now at 1% in core. Also, market seems to be quite short BAs, OI has surged (bottom panel of chart above).

False breakout out in CAD/JPY in the making? 



Here I get some long Yen exposure back. I originally wanted to look at something like short CAD/NOK to remove the oil input, as the KSA strategy of capping exports to the US seems to be working with US inventories drawing at relatively high rates. So while I think a position like that is valid, the shorts in yen look overdone and the CAD short covering seems to be ending. This is also an intriguing structure as a way to fade "coordinated tightening." If the market discounts hawkish CB rhetoric as more bark than bite, or if Draghi pushes the breaks and gives duration a big boost, loonie/yen will do poorly.

End on dollar liquidity 

For the past two posts I have spent a lot time going through my H2 dollar thesis. I am still of the view, the tremendous surge of dollar liquidity since December, has been a large contributor to some of the interesting dynamics we have seen in markets this year. Large narrowing of dollar funding in cross currency basis, low cross asset vol and a loosening of FCI's despite a Fed hiking cycle; the common denominator seems to be in the plethora of dollar liquidity. As I have tried to explain, as the debt ceiling hurdle is cleared and Treasury bill issuance is forced to pickup, dollar liquidity will become much more scarce. I will return to this topic in the coming months, as the Treasury may be forced to act faster than they think, 3s6s in bills are already inverted and the deficit is looking quite precarious.


This seasonality chart shows that budget deficit in June was the biggest in five years. Typically, June is month of narrowing and July/August, is when the steepest deficits occur. If that trend is still the case, the US budget could get pretty nasty over the next few months, as people and firms still try and differ tax obligations under guidance to wait for tax reform. Mnuchin may need to push congress quicker than he thinks.


Thanks for reading,

Jonathan Turek

July 6

As the Fed has seemingly transitioned from being focused on returning PCE to target, to FCI's, the board is ignoring negative credit developments for the sake of a liquidity wave they are struggling to understand. One thing I have noticed this year is, both the Fed and the street seem to have bundled "credit" and "liquidity." The reason I want to deal with this topic is I think it is fundamentally rooted in my dollar thesis from last post. The emergence of dollar liquidity has clearly confused signaling metrics across markets. The Fed is thinking they are behind the curve in FCI's and with U3 so low, they feel they have the rope to play some catchup. The fear now is, as they usually do, the Fed will overstep as they incorrectly read these liquidity drivers and move to remove accommodation despite slowing PCE. What makes this worse is, if my dollar thesis is correct, by instituting their proposed SOMA adjustment policy from the June addendum, the Fed will be doubling down on what will be receding liquidity as the Treasury rebuilds their cash balance through increased Tbill issuance. In my view, this brings us back to a world that is structurally dollar challenged. So, the topic of this post is, why liquidity and credit are sending different messages, and by bundling them the Fed and the street are missing significant nuance and context in their respective outlooks.

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

Post June 6

Hope all is well and everyones summer is off to a good start. For this note I am going to go with a different approach. In prior posts, I have gone with a macro themes and trade ideas. For this year, that has been slowing U.S. economic growth and a rally in rates, especially in the back end. So this note will encompass two distinct shifts; first it will not be me presenting a trade idea necessarily, and second, one of my mentors conveyed to me that I should "spell things out and not use abbreviations/vernacular so often," so in this post I will also attempt to be clearer with my thoughts. As Tolstoy said, "true life is lived, when tiny changes occur."

The topic I am grappling with is what has been a refunding of dollar liquidity since the end of 2016. Of course my core competency is typically in broader macro and not money markets, but the macro consequences of this "dollar" move has forced me to do some homework.  I hinted at this topic in my last post, when I talked about the potential for "counter flow" in USTs on the back of cheap dollars. So, this year alone, the rush of dollar liquidity has led to, FRA-OIS back near 11, which has caused a lot of suffering for ed$ puts, cross currency basis swaps (XCCY) are significantly tighter, EMFX is ripping and risk assets in the developed world have surged as financial conditions are near their easiest levels since 2014. The question the BIS has been asking, what unleashed all of this dollar liquidity? I am not sure it is definitely one thing, but this post focuses on one variable in specific, the US Treasury. Could have money market fund adjustments post 2a-7 normalized FRA-OIS, could the increased oil price post OPEC cuts have helped free up some petrodollars, could China's capital controls have kept Asian currencies in check, did the expectation of regulatory relief in the form of easing Basel III from the new administration play a role in increasing bank leverage. All are possibilities, but I am going to focus on the role of Treasury and why this reliquification of dollars is likely unsustainable if underfunded Uncle Sam is the culprit. The biggest reason I feel strongly about the US Treasury being a key variable in this dollar liquidity equation is, the evidence (presented below) suggests that something changed in late December of 2016 in terms of dollar funding, this happens to coincide with the Treasury's cash balance falling by around $350b, providing the global banking system with much needed dollars. The question is, if the treasury needs to reload in terms of issuance, as they will likely have to do later this year, does that suck up all of this dollar liquidity. What has stoked this fear for me is that the Fed is looking likely to change their SOMA policy by year end as they cannot tolerate this relentless flattening in the curve (I do not believe a tepid b/s rolloff through caps will steepen the curve, I have touched on that in previous posts). The combination of b/s roll offs and Uncle Sam desperate for cash (need to extend debt ceiling) with twelve month trailing tax receipts negative, dollar liquidity could get soaked back up again and the dollar shortage theme will remerge.

Part of the reason I am fearful of this topic is, the knock on effect onto my core positions in rates is somewhat unknown to me. If dollar liquidity is again to recede, do USTs act as a guaranteed claim on USD long term, or does what I talked about last post, the potential for counter flow in this "cheap" dollar world end, and force trade surplus nations to cover their effective dollar shorts, i.e. selling dollar reserves. I guess my transition into Q3 and onwards could look to be long dollars, which is now becoming a consensus short. Monitoring Treasury refunding statements and debt ceiling developments will be crucial in assessing when this dollar liquidity train will halt and the right timing for putting on dollar longs. The knock on effects of this are significant to EM, China and thus the Fed.

How did we get here?

If one is to look at where dollar liquidity would manifest itself, for me, there are three key places. First, EMFX will always show you as EM is structurally short around $10.5T in dollars according to the BIS. Second, funding markets through FRA-OIS and XCCY will give you a decent idea. Third, is in FCI, as credit is so intercorrelated to commodities, dollar liquidity always plays a big role in determining financial conditions. In a paper last year, the BIS deemed the dollar as the new VIX. Well, since the middle of December, the Fed has hiked twice and raised the dots and their December meeting in hopes of tightening financial conditions, at least to an extent. The response has been remarkable, from EM to credit spreads in the U.S.

Mnuchin's Unintentional dollar QE. US TSY Cash Balance vs FRA-OIS



While the Fed was busy tightening the screws, the Treasury, in hopes of avoiding the debt ceiling unleashed a wave of dollar liquidity by paying down its cash balance. The ripple effect has cost ed$ put buyers a lot of money, as FRA-OIS has been crushed by this rush of liquidity. So in a sense, during the Fed's "tightening" cycle, we are witnessing the easiest financial conditions since '14, a bull market in EMFX and credit spreads near their tights. What has contributed to me thinking the big catalyst in this liquidity rush, is the massive drawdown in the Treasury cash balance, as the response in timing seems to match the beginning of Q1.

Something Changed at the very Beginning of Q1

So effectively, as the Treasury's cash balance was taken down, cross currency basis swaps tightened. One of the reasons I find it likely that this catalyst is more likely then say a regulatory shift that would free up bank balance sheets for arbitrage, is that these changes take time, and as we see above, the three month basis in EUR has moved considerably tighter. So to me, it looks more likely that Treasury was the catalyst in freeing up cheaper dollars. 

Rip fest in dollar liquidity seen in XCCY, coincided with TSY move in Cash Balance



It just cannot be coincidental that as the Treasury essentially flooded the system with +350B of reserves, there was massive narrowing in $/DM FX basis. What has also helped, especially in the EUR basis, is the relative calm in the banking sector. Towards the end of last summer, when DBK was collapsing, EUR 3 month XCCY was blowing out, as funding pressures reverberated throughout the European banking system. As the EGB curve have steepened a bit, banks are hanging in. To me, curves, especially in the core, could be ripe for flattening as inflation slows. The ECB will conscious of this effect on the banks and pensions. Another reason why I like EUR shorts, what if receding dollar liquidity from increased Treasury issuance coincides with flattening curves in the core?

German Inflation (April # below) is in Trouble if China Slowing Persists



This chart already served me well going into the May flash HICP inflation number, but a slowing of Chinese imports will continue to weigh on price pressures in Germany. Given slowing inflation and carry+roll in the belly, it should stay relatively bid. This will only be enhanced if dovish Mario ignores scarcity concerns in his PSPP program.

EMFX v FRA-OIS, One in the Same

What has become clear is that something reversed EM flows towards the end of last year. Going into December, EM was a consensus short as the Fed was poised to steer more hawkish and the dollar was advancing. But, following the Treasury's move to stave off debt ceiling, dollar liquidity flooded the system and EMFX ripped. Of course this was helped by increased Chinese aggregate demand on the back of expanded fiscal moves in the industrial sector, but that was already taking place on a lagged effect since Q3. Something staved off a dollar shortfall in Asia, my feeling is it was the US Treasury, unbeknownst to them. The question is, why did EMFX ignore a hawkish FOMC path at the same time the US Treasury was staving off debt ceiling by paying down its cash balance. Unfortunately for EM, this has created a false sense of dollar calm. So far this year, we have seen record USD issuance. in Q1, EM governments issued a record $179B in USD denominated debt. Effectively EM on quarterly basis, went limit short dollars and on what appears to be a false sense of liquidity. If this dollar liquidity is really just temporary, crowded EMFX and rates could be hit hard later this year, and this space is already crowded on the long side. If Treasury issuance is to ramp, I will be looking back at some shorts in Asia FX, especially currencies with poor FX reserve adequacy levels.

EMFX Carry Returns (%) Since Treasury led Dollar Liquidity Wave, Coincidence? 



Forwards Curves in TWD and KRW, Big Move since pre-Dec FOMC



This could set up for some decently convex option structures in Asia FX, if this paradigm of cheap dollars is to shift later this year. 

Fra-OIS (inv) v 10 EM country FX reserves

With domestic currencies on a tear, many EM countries have used this as a time to pickup some FX reserves, something they have been shedding since 2014. It is not surprising that this pick up has correlated to a collapse in FRA-OIS. In my last post I talked about the potential for this to occur in China, as the currency looked stable given interest rate differentials and "stabilization" in the capital account. Now, we are hearing China is looking to pickup some USTs. The problem is, if China is to experience dollar problems, like they did in the latter months of last year, the trickle effect in EM is significant. It is worth noting, the BIS assumes that 80% of foreign currency loans in China are USD denominated and half of the foreign debt owned by Chinese firms is in USD. As the rest of EM has done in Q1, Chinese firms effectively went massively short dollars in Q3 as foreign debt owed by Chinese firms skyrocketed to $1.2T in Q3. So the Fed could be beginning balance sheet reduction at the same time the Treasury is reloading its cash balance, and while all of this is going on, EM got massively short dollars again in the few quarters before. Q4 of this year should be most interesting if Treasury is really the cause of this abundance in dollar liquidity. 

Credit Spreads near Tights and Financial Stress Index at lows



Post Treasury move reaction, highly visible in credit spreads and the Financial Stress Index. Both have compressed to their tightest levels since 2014. It is worth reminding, this move will encompass three Fed hikes after the June meeting next week. But, if your approach is that the bank funding has functionally replaced Tbills as the Treasury lowered supply, is it surprising that banks "feel" better, they just got a boat load of cheap liquidity. 

Commercial Paper Outstanding Correlates to Asian Dollar Index



So as the Treasury frees up dollar liquidity, it makes sense for CP issuance to correlate to Asia FX. As LIBOR underperforms banks increase CP issuance, which they have basically had to as Tbill funding looks for an alternative. CP is also a key dollar funding source for foreign banks. As banks relevered, dollars were provided to the broader system and carry was aggressively chased. 

To show how interconnected the Treasury is in all of this we can trace back. As the Treasury went through its cash balance and reduced bill issuance due to debt ceiling concerns, cash pools had to access the market for bill equivalents in o/n bilateral repo. This led to distortions in GC repo v LIBOR. After the Treasury's move at the beginning of Q1, this spread blew out as the lack of bill supply flooded the bilateral market with cash. As we can see, this spread is beginning to normalize. 




It Does Not Look Sustainable, Treasury has to Reload and the Fed Lurks

What has become popular on the street is the Treasury's refunding statements. The May release drew a lot of macro interest. However, I think this interest was misplaced. The street seemed to be obsessed about 50 year bonds, something Mnuchin has hinted that he is inclined to pursue. Extending maturities makes sense, so the duration impact was obvious. Not surprisingly however, dealers were skeptical of the idea and seemed to prefer increasing issuance of longer dated maturities. This is not entirely surprising because without a change in capital requirements, it is more costly for dealers to warehouse long duration risk. However, this should have been side point. The real question is how does the Treasury reload in terms of refunding this year and when? Treasury needs to run a higher cash balance and Tbill issuance has to ramp to facilitate that. This will bring government back to doing what it does best, crowding out. What could make this worse is that the May TBAC assumption for the Fed was that SOMA changes would begin in June 2018, not this year. If the Fed is doing roll offs in SOMA at the same time issuance at the Treasury is ramping (would need to more issuance than expected if Fed moves on SOMA this year), dollar liquidity will come down significantly as these two sources of reserves are sucking it all up. 

Source* TBAC Presentation to Treasury in May

The Fed's balance sheet shifts would have its own effects on dollar liquidity as there are significant ramifications on money markets, bank deposits, IOER, RRP and increased demand for HQLAs (high quality liquid assets). A reduction in the overall size would force banks to buy more USTs to satisfy their Liquidity Coverage Ratios for HQLAs, which also sucks liquidity from the system. So banks could be changing IOER balances for HLQAs at the same time as the Treasury drastically increases Tbill issuance to normalize their cash balance post debt ceiling. This feels like trouble. 

Just a reminder, according to the BIS, a stronger USD leads to wider Covered Interest Parity deviations in cross border bank lending. Bruno and Shin (2015b) model.



"A stronger US dollar is associated with wider CIP deviations and lower growth of cross-border bank lending denominated in dollars. We interpret the magnitude of CIP deviations as the price of bank balance sheet capacity and dollar-denominated credit as a proxy of bank leverage, and argue that such a triangular relationship exists because of the impact of the dollar on the shadow price of bank leverage."

BIS November '16: The dollar, bank leverage and the deviation from covered interest parity
(Stefan Avdjiev, Wenxin Du, Catherine Koch and Hyun Song Shin)

The Rates Conundrum. If Dollar Becomes a Problem post Debt Ceiling.

Just to leave you with a thought, as I will likely spend my summer trying to figure out if a "dollar" event is to transpire, what are the effects on US rates.  Can the dollar rise with falling rates? Well it did in '92-'93....... With that said, back end USTs should continue to rally as 2.15 still does not properly reflect growth and inflation both below 2% for 2017, and Fed that seems determined to get off the zero lower bound. See previous posts for more on my US macro view. 




Thanks for reading and all the best,

Jonathan Turek