Global USD funding shortfall pressures becoming more acute
July 8, 2019
Even before Friday’s better than expected jobs data, dollar bears had reason to be nervous. Despite the massive decline in interest rate expectations, doubts over the Fed’s independence, the implementation of a functional alternative global payments system (circumventing the USD) and rising twin deficits the dollar remains surprisingly well bid and within 2% of the highs of the year. Even President Trump’s threat to engage the US in the same currency manipulation that he accuses other countries had virtually no adverse impact on the price of the dollar. Occasionally, what doesn’t happen in the markets is as telling as what does happen. This is one of those times and a sure sign that the setup for the dollar is now skewed asymmetrically to the upside.
We’ve written previously about the growing dollar shortage as a result of a smaller Fed balance sheet and declining international trade volumes, making it more difficult (and expensive) for leveraged corporate and sovereign entities to access adequate funding. The potential impact on financial markets worldwide continues to be largely both misunderstood and underappreciated. A strong dollar, driven by increasing scarcity, risks creating its own negative feedback loop, tightening financial conditions and slamming the brakes on a global economy that is already decelerating. It’s the ultimate pain trade, and the odds of it playing out that way are rising.
Look no further than the news out of Europe last week for evidence that the liquidity problem is becoming more acute. Negative interest rates have already impaired lending and crippled the banking system, but the new head of the European Central Bank somehow thinks that policy has been a success. See https://on.wsj.com/2KWOg12. What? With inflation expectations literally collapsing, under LaGarde’s leadership, the ECB will likely cut rates even further, driving the banks into the ground as access to funding becomes ever more problematic. Deutsche Bank is the first to be forced into a massive restructuring but it won’t be the last. See https://reut.rs/2YEjI7N. As the old expression says, there’s never just one cockroach.
The resilience of the USD on the FX markets is a sign that investors are in the process of discovering that the central banks may not be able to easily solve the problems resulting from the dollar funding shortfall. The upside trade is clearly the path of least resistance. Last month’s pullback in the dollar index (DXY) held at 96.00, roughly the same level it finished 2018. This becomes major support and a point for long positions to now lean against.
We’ve been bullish on the dollar and bonds for months. (See The Dollar and Deflation, April 29) Bonds have worked out, and have much more to go. While the FX component of that trade has been dead money so far, it feels like the dollar is getting ready to spring back to life.