Tag: Forex Trading

China: Red Flag Rising

Photo by Alejandro Luengo on Unsplash

Despite a quick reopening, a crack in the Chinese currency suggests things are about to get worse for the world’s second-largest economy.

Written May 24, 2020

The Chinese yuan finished last week near its lowest level in more than a decade as investors began to bet with their feet, heading for the exits over concern that the country is compounding its economic problems with geopolitical moves that are already generating widespread condemnation and even greater uncertainty.

The post-pandemic economic landscape presents a test for the regime that has long prided itself in delivering on an unspoken bargain where one-party rule is tolerated in exchange for consistent economic growth.

However, a sure tell that the government’s grip is slipping was its failure to set an economic growth target for the upcoming year during last week’s National People’s Congress, the annual planning meeting of the Chinese Communist Party. It might seem like an insignificant detail, but for the first time since it began providing GDP estimates in 1990 the central body declined to be bound by a projection that it may not be able to meet. It is a big deal, and the obvious conclusion is that the economy on the mainland is worse than it outwardly appears.

China’s recalcitrance in dealing with COVID-19 has also turned global public opinion against it. As a result, doing business with the Chinese in the future is going to come under much more scrutiny than in the past.

Despite the allure of 1.4 billion potential consumers, it now won’t be so easy to turn a blind eye to the tilted playing field China has erected to their advantage, as much of the world has done since China’s inclusion into the World Trade Organization in 2001.

The U.S. Senate took the first step last week by passing a bill by a 100-0 margin requiring Chinese firms to adhere to American accounting standards or risk being delisted from our exchanges, also a big deal. Other measures will follow.

The pandemic exposed many countries’ over-reliance on Chinese manufacturing and is forcing most to reconsider basing their supply chains elsewhere. Japan even earmarked part of its economic stimulus fund specifically to help its manufacturers shift production out of China.

The bottom line is, the rules of international trade are being rewritten and China is not going to like the changes.

Further complicating matters, China is lashing out at the west’s insistence on an investigation into the origins and handling of the virus. Within the space of a few weeks they’ve made moves to block certain Australian exports, threatened to cut off the supply of critical pharmaceutical ingredients to the U.S., and imposed their own national security laws on Hong Kong. So much for the idea of “one country, two systems” that was the founding principle agreed to by both parties when the British turned Hong Kong over to China in 1997 and that has allowed the former colony to thrive as an international financial center.

Not content to stop there, the Chinese navy is scheduled to begin live-fire military exercises later this month as part of an amphibious assault training operation on an island controlled by Taiwan. As the Wall St. Journal asked in a May 21 op-ed titled “China Moves on Hong Kong”, is Taiwan next?

At the risk of stating the obvious, political isolation from global trading partners can only be seen as a negative for the economy.

Plan A for Chinese authorities to counteract these economic headwinds is with traditional fiscal and monetary stimulus, along with a heavy dose of infrastructure spending. But the effectiveness of that approach is questionable as the country is already swimming in overcapacity, and debt. It’s the demand side of the equation that is lacking.

Plan B would be a devaluation of the currency, which the market is beginning to sniff out. In theory, this would spur demand by making Chinese-produced goods more competitively priced. In reality, it would propel the dollar higher, unleashing a deflationary wave on a world already under enormous pressure from falling prices.

The Fed and other central banks have done an impressive job of rescuing the credit and equity markets from the depths of the pandemic panic in March, but a Chinese devaluation would slam the lid on any hopes of reflating the global economy.

Our core portfolio positions remain long of the US dollar, front-end treasuries, and gold.

Going Negative

Photo by Ussama Azam on Unsplash

Debt deflation starts the U.S. on a path to negative interest rates

Written May 10, 2020

Last week, for the first time in the country’s history, the financial markets began discounting the possibility of negative interest rate policy.  

On Thursday, the December Fed Funds futures contract settled above par (100.00), implying that traders have moved beyond talking in the abstract about negative interest rates and started betting with real money that the Federal Reserve will be forced by events into crossing a line they’ve long insisted they would not step over. 

Japan, Europe, Switzerland, Sweden, and Denmark currently have negative interest rates, policy legacies left over from fighting the last recession in 2008. The theory was that people would be so repulsed by having to pay a bank to hold their money that they would gladly spend it instead, stimulating the economy in the process. It hasn’t exactly worked out that way.

Rather than driving consumer demand, negative interest rates have resulted in a minefield of unintended consequences. Besides the lack of confidence it conveys to the public on behalf of impotent policymakers, it has clogged the banking system and perverted the lending process.

Count us among those who previously thought there was little chance that the Fed would follow the rate policies of its Japanese and European counterparts. But as we recently wrote in “The L-Shaped Recovery“, the pandemic has exposed and accelerated the threat of debt deflation that could end up triggering waves of bankruptcies.

The deflationary scenario was brought into stark relief after we recently came across a chart overlaying the Economic Cycle Research Institute’s Weekly Leading Index (WLI) with the US consumer price index (see below). As the name suggests, the WLI anticipates economic activity 2 to 3 quarters in the future. If the correlation with the CPI holds, it means prices could begin dropping later this summer.

Just as the value of debt falls in real terms in an inflationary environment, it rises in deflationary times. The problem is compounded by declining cash flows as a result of weak economic activity, making it harder to service that debt and potentially creating a serious problem for highly leveraged economies like ours.

The other moving part in the relationship between debt and deflation is the U.S. dollar. If the Fed’s policy rate is anchored at zero and market yields can’t keep pace with falling prices for goods and services, real yields (the nominal yield minus the rate of inflation) will rise, driving the dollar higher and depressing the price of imports domestically and commodities globally. As we said in “The Biggest Trade in the World“, “the risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.”

As has been the case with every rate cut in this cycle, the market will lead the way for the Fed’s next move. And given the risk that rising real yields could pose to the prospects for a recovery, investors are concluding that the Fed may have no choice but to take rates negative.

Besides being long-time proponents of the U.S. dollar and front-end treasuries as core investment themes, we recently recommended adding a position in physical gold. Gold may be subject to bouts of selling if the dollar continues to rise, as many traders still reflexively see the two as inversely correlated. But because there doesn’t seem to be any limit on central bank money printing, gold will shine as the ultimate store of value in a world of increasingly negative interest rates.

Economic Cycle Research Institute Weekly Leading Index vs US Consumer Price Index. Chart courtesy of Real Vision.
December 2020 Fed funds Futures, trading above 100 for the first time ever and implying negative policy rates in the U.S.

The Biggest Trade in the World

Photo by Vance Osterhout on Unsplash

The largest position in the history of the financial markets is about to get squeezed.

Written April 27th, 2020

Successful traders are always asking themselves two questions in the course of analyzing markets: 1) given a set of known inputs, are markets behaving as expected? and 2) if not, why not?

Since the COVID-19 pandemic crashed the world’s financial markets last month, central banks have responded with extraordinary measures to stabilize markets and prop up their respective economies.

For its part, the Fed has undertaken policies on a scale unprecedented in the history of finance, radically expanding their balance sheet and going so far as lending directly to municipalities and buying junk bond ETFs in the open market. Essentially printing money, but on steroids.

The equity markets have responded favorably, much as one would expect given the deluge of liquidity. It’s a reflexive response conditioned by a decade of the Fed propping up asset prices every time the markets stumbled. Will it last? Nobody knows.

However, the part of this scenario that is not going according to plan is potentially the most consequential for the financial markets. The US dollar needs to weaken. Big time. For a global economy staring at a tsunami of deflation, it is the most critical element to achieving a durable reflation of commodities and equity prices and restoring confidence in many regions of the world, especially the emerging markets.

This is not lost on central bank officials. In fact, if you were asked to come up with a policy to destroy your own currency, moves by the Fed and the Treasury over the past month to explode the federal deficit would be it.

The speculative trading community initially took the cue. According to CFTC data, the specs began shorting the dollar in the middle of March as rates went to zero and the money printing presses began working overtime.

But since then, not only hasn’t the dollar gone down, it is higher instead.

The latest study by the Bank for International Settlements estimates the world’s short position in the dollar at about $13 trillion, much of it based on dollar debt held by offshore banks and corporations, representing the largest aggregate position in the financial markets by far.

Currency swap facilities instituted and expanded by the Federal Reserve with the intention of ensuring these entities access to dollar funding helped settle the markets late last month, but the currency’s appreciation since then is a sure sign that it won’t be enough. For many of these foreign corporations, swap lines are of little value if their respective central banks don’t have sufficient reserves to swap or US Treasury securities to pledge as collateral.

Also, printing trillions won’t do much good if there is no turnover, or velocity, of that money due to the collapse in business activity. It just ends up in the vaults of institutions that don’t need it, crowding out the weaker borrowers.

Against all expectations, the steady grind higher in the dollar in recent weeks is a red flag that this massive short trade is about to get squeezed.

The implications will be felt everywhere. The risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.

As we’ve been recommending for more than a year, stick with long positions in the dollar and front-end treasuries. In our last piece “The L-Shaped Recovery“, we suggested adding physical gold and taking advantage of near-term strength in equities to reduce exposure. If the dollar starts to accelerate, things could get ugly. Quickly. And despite the Fed’s insistence on not taking interest rates negative, it’s not impossible that this will end up being their next move.

US Dollar Index (DXY)

Tipping Point

Declining economic growth may become too much for equity markets to ignore

Photo by Michał Parzuchowski on Unsplash

Written October 2, 2019

Yesterday’s sharp deterioration in risk sentiment is a sign that the equity market and its patrons at the Fed may have a couple of serious problems: 1) The latest numbers from the Institute for Supply Management (ISM) suggests the US economy may be close to, or already in recession and 2) the Fed has been too slow to recognize it. Neither of these issues is exactly new news but the stock market’s seemingly oblivious reaction to the growing danger has been nothing short of remarkable. Until now.

The continued erosion of benchmark ISM survey data on U.S. manufacturing, its worst reading since 2009, was punctuated by a complete collapse in the forward-looking new export orders component. See https://bloom.bg/2oWfXgK. The disruption in commerce and global supply chains from trade wars is real and intensifying. Similarly, contractionary readings on factory production from China and Europe this week only added to the recessionary drumbeat.

It is undeniable that the Fed underestimated the deceleration in the economy. Their hesitancy to ease when signs of economic weakness first appeared earlier this year probably means that a recession is now inevitable. They missed the boat. Even if the Fed cut rates aggressively now it may not matter. And that possibility is starting to occur to investors who had come to rely on the Fed as a consistent backstop for asset prices.

It feels like the markets are at a tipping point. The major central banks have spent a decade throwing trillions at the economy and have little to show for it except for unprecedented levels of income inequality. But it hasn’t stopped them from pressing forward with more of the same policies. The renewed race to the bottom on interest rates is becoming less effective while at the same time increasingly desperate.

The failed WeWork IPO might have rung the proverbial bell in this era of easy money and stretched valuations. Fundamentals matter. Earnings, which they clearly don’t have, matter. Like Pets.com, the poster child of absurdity from an earlier bubble, WeWork will go down as an example of “what were they thinking?” for years to come. See https://bit.ly/2nE1y8N.

As I noted in my two previous pieces (see VIX Cheap as Impeachment Threat Grows and Liquidity Trumps Fundamentals), the most obvious trades in this shifting paradigm are to be long volatility and long the front-end rate market. Historically, October is more volatile than most other months. And the lurch lower in key economic data points could be the catalyst that makes volatility in equities, bonds, and FX all suddenly appear to be ridiculously underpriced.

Furthermore, anyone who doubts that the Fed could take rates back to zero, and quickly, has not looked at the U.S. dollar. The growing global dollar shortage, which we’ve written about extensively, is pushing the buck up through multi-decade resistance (see Fed Rate Cut: Too Little, Too Late). The long term dollar index (DXY) chart is very bullish, and if the USD gets legs it will make the 2018 emerging market selloff look tame by comparison. The Fed can’t afford for that to happen and will be forced to keep cutting rates to try to prevent it.

US dollar index (DXY). Breaking out higher.
Emerging market ETF (EEM). Look out below. A stronger USD leaves this sector very vulnerable.
CBOE volatility index (VIX). Cheap and bullish.

Enjoy the Party but Dance Near the Door

Reason to be skeptical of the latest central bank reflation trade

Photo by Filios Sazeides on Unsplash

The title of this piece refers to an old cautionary Wall Street cliche that describes a trader’s dilemma where the price action says one thing but his gut warns him that something is not quite right, and to not get too complacent. This is an apt description of the current state of play over the past few days. Markets are reacting optimistically to a potential trade deal with China and the prospect of supportive policy intervention by the major central banks, most of which involves creating more debt. Besides possible rate cuts by the Fed, BOJ, and ECB, China unleashed another huge credit impulse, see https://bit.ly/2kAGnTz, South Korea has enacted a massive fiscal spending program, see https://on.ft.com/2ZBihGx and the Germans are exploring ways to circumvent current limits on debt issuance, see https://reut.rs/2kDcsKl. That’s a lot of stimuli. No wonder the markets like it.

However, this collective panic among the policy crowd in the face of slowing economic growth doesn’t offer any new ideas other than to throw more money at a situation that previous waves of cash have failed to fix. Most investors now realize that after a decade of extreme monetary policies, excessive debt is becoming the problem, not the answer. It’s the reason why large parts of the world are trapped in a deflationary malaise. Not only will piling on more debt not work, but it will also make the eventual reckoning even more painful.

Since early this year we have focused on several trends: slowing global growth, falling rates, and a stronger dollar. A continuation of these generally-bearish themes, along with the pressure that it exerts on the vulnerable corporate credit and emerging market sectors, is still our base scenario.

Nevertheless stocks, yields, credit, and commodities have all caught a bid in recent days. The dollar is offered. With good reason, investors still strongly believe that the central banks can affect outcomes and that a safety net is firmly in place under the markets. One of our favorite risk sentiment canaries, the Canadian dollar, impressively held support at USDCAD 1.3400 (see chart below.) This is a sign that a broader recovery in the marketplace in the near-term is not only possible but likely.

Longer-term, the prospect of a global economy that is weakened by over-indebtedness and unable to maintain sustainable growth without the repeated intervention of central banks is a frightening prospect, and remains our primary concern. The big danger in our future will come at that point when investors lose faith in central bankers’ ability to keep the markets propped up. We’re not there yet but that re-set in valuations will be the trade of a lifetime…and not in a good way. Will it be next month, or next year, or five years from now? Nobody knows. So in the meantime enjoy this latest bull party but remember to dance near the door.

USD/CAD. The Canadian dollar (CAD) is a reliable indicator of global risk sentiment. Stronger CAD is bullish for asset prices.
US dollar index (DXY). Fails to break out higher, also bullish for asset prices, especially emerging markets.
Benchmark US 10yr Yield. Bottom in for now as broad risk sentiment recovers.

Fed Rate Cut: Too Little, Too Late

Strong dollar poses risks for reluctant policymakers

Photo by Colin Watts on Unsplash

August 4th, 2019

The Fed cut rates by 25 basis points (one-quarter of a point) last week, as expected, amid signs of slowing global growth. Chairman Jerome Powell tried to reassure investors that the economy was still on solid ground and that the move was merely a “mid-cycle adjustment”, not the beginning of a prolonged easing cycle. Don’t bet on it. Persistent strength in the US dollar is both a sign and a reason why a recession is closer than they think.   

As we’ve noted repeatedly here before, the US dollar is the Achilles heel of the international financial system. Through their easy-money policies in the wake of the 2008 recession, the Fed encouraged a massive buildup in leverage by both sovereign and corporate entities. Unfortunately, to service that debt borrowers are negatively exposed to any decrease in the supply or increase in the price of those dollars.

In the past year, slower global growth, declining international trade volumes, tighter US monetary policy and a reduction in the Fed’s balance sheet have all contributed to a reduction of dollar liquidity in funding markets. This fundamental shortage of dollars has driven its price higher on FX exchanges. In 2018 a strong dollar roiled the markets (especially emerging markets) before the Fed was forced to pull the plug on its monetary policy normalization plans in the hopes of capping the currency’s rise. It worked, barely. After pausing for a couple of quarters the dollar is on the move again as the global shortage intensifies. See https://bloom.bg/2YnU5fh. The path of least resistance is clearly higher, perhaps significantly, and it’s going to take a lot more than one rate cut to turn it around.

Compounding the dollar squeeze is the current budget bill crafted by congress, which eliminates the debt ceiling for the next two years and allows US government spending to increase virtually unchecked. To meet these new financing needs it is expected that over the next several months the treasury will need to raise $250 billion in fresh cash, further draining the supply of dollars in the system. See https://on.wsj.com/2SXVJOE.

Despite the shift toward easier monetary policy, the broad dollar index (DXY) climbed to its best level in two years. The FX market’s message to the Fed is unmistakable: the cut in rates was too little, too late. The risk for policymakers from here is that a stronger dollar will create deflationary headwinds, possibly tipping weak economies into recession, and force the Fed to cut rates deeper than they’re willing to admit.

The US dollar, breaking out.

Loonie Set To Get Its Wings Clipped

Canadian dollar vulnerable to drop in energy prices

Photo by Michelle Spollen on Unsplash

July, 21, 2019

Energy is by far Canada’s largest export and production accounts for close to 10% of the country’s annual GDP. Subsequently, the Canadian dollar, colloquially known as the Loonie after the bird featured on the back of the dollar coin, is heavily influenced by the state of play in that sector and rarely strays too far from the prevailing trend in commodities prices, especially oil.

So far in 2019, the CAD has ridden a rising tide in stocks and commodities as the major central banks, led by the Fed, try to reflate the markets and breathe life into an aging economic cycle.

The promise of plentiful liquidity has been generally successful in driving financial markets higher, but we have doubts that this strategy will produce a meaningful boost to actual growth. One reason for that skepticism is derived from the distinct underperformance of the commodities complex this year (see chart below.) As a macroeconomic benchmark, commodities appear to be far less optimistic on the future than the message coming from the stock market. Like any divergence between normally-correlated markets, it could mean nothing or it could be an important message. Time will tell.

Oil, in particular, has had a very bad week when perhaps it shouldn’t have, given the tension with Iran in the Strait of Hormuz where 20% of the world’s petroleum supply passes. See https://bit.ly/2Y5BJyI. Prices in the futures market are down more than 9% and the energy sector as a whole looks vulnerable to further pressure. It’s tempting to sell commodity-sensitive currencies on the bet that they will follow suit.

Shorting the Canadian dollar represents an attractive risk/reward proposition. Not only is it still within 0.5% of its highs on the year (vs USD) but unlike most of its peer group of commodity currencies the speculative community is long and leaning the other way.

Calling turns in any market is tricky. We like owning USD/CAD here as long as it holds 1.3000, a risk of less than 1%. We think it’s a good trade but if we are wrong it won’t cost a lot to find out.

If you would like to discuss this or any other trading strategies please feel free to contact us at atradersperspective@gmail.com.

As a forward-looking indicator on the economy, commodities (blue) are decidedly less optimistic than stocks (orange).
The Canadian dollar (orange) and XOP, the oil and gas exploration ETF (blue). Both are vulnerable.

Dollar Coming Back to Life

Global USD funding shortfall pressures becoming more acute

Photo by Jp Valery on Unsplash

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.

US Dollar Index (DXY). Longs can lean against 96.00.

Aussie-Yen: Currency Canary Keels Over

June 14, 2019

Coal miners used to carry caged canaries down into the mines on the theory that any presence of dangerous gases would kill the birds before the humans and serve as a warning for workers to exit the tunnels.

Over the years the term has evolved as a metaphor for early signs of trouble in the financial markets.

The Australian dollar (AUD)/Japanese yen(JPY) FX pair is probably the best-known benchmark of risk sentiment, with a well-deserved reputation as a leading directional indicator for markets in general.

On one side is the Aussie dollar, a liquid high-beta currency that is reflective of prevailing global macroeconomic trends, and on the other is the yen, best known as a reliable safe harbor destination in uncertain times. If that pair is rising (AUD outperforming the yen,) it most likely means economies are expanding, markets are happy and the outlook for asset prices favorable. If it’s falling (JPY outperforming,) the opposite. Simply, AUD/JPY is the ultimate canary in the Wall St. coal mine.

International trade and supply chain disruptions have taken a big bite out of global growth. Despite the slowing economy, expectations of even more central bank stimulus have kept financial asset prices elevated. But that fundamental divergence can’t go on forever. The Fed has some room to cut rates but in most other countries yields are already at historic lows while world-wide debt stands at record highs. Investors appear to be slowly coming to the conclusion that more of the same policies aren’t the answer. Either growth needs to accelerate or there has to be a reset lower in the financial markets. The breakdown underway in AUD/JPY is a sign that the canary is keeling over and that the latter outcome may be unfolding.

The AUD/JPY FX cross and the emerging market ETF (EEM) are both headed lower.

Fed Rate Action Could Boost India Modi Euphoria

The re-election of Prime minister Modi and potential rate cuts from the Fed have been well received so far but the general softening in global growth remains a threat, especially to the emerging markets.

June 12th, 2019  

I have joined the team at ConnectedtoIndia.com as a special contributor, providing market commentary with an Indian angle. 

The euphoria in Indian stock markets after the recent reelection of Prime Minister Narendra Modi’s National Democratic Alliance could find further support next week if the US Federal Reserve decides to do an abrupt turn in its interest rate policy, from raising interest rates last December to possibly reversing that decision at its upcoming meeting.

Bombay Stock Exchange Photo courtesy: Wikipedia

Bombay Stock Exchange Photo courtesy: Wikipedia

A US interest rate cut would help provide assurances to India and the rest of the world that dollar liquidity in offshore financing markets will remain plentiful.  This has already brought relief to market risk sentiment, at least for now. Despite some signs of profit-taking today, equity prices in general across all sectors are up sharply in the past week since the Fed hinted at the move.

Weak global economic growth made worse by intensifying international trade tensions is squeezing the finances of many export-dependent countries, drawing comparisons to the turmoil last year that began in the emerging markets and later spread to developed economies.

Currencies of China, Turkey, South Africa, and Brazil, where the first signs of trouble appeared in 2018, have recently come under pressure again.  This has attracted the attention of central bankers, notably Federal Reserve chairman Jerome Powell, who are eager to head off a repeat performance in 2019.

Many countries, as well as corporate entities, took advantage of cheap dollar loans at low rates during the Fed’s easy money regime in the wake of the financial crisis of 2008.  The resulting increase in leverage left these same borrowers negatively exposed as the Fed began to unwind those policies in earnest beginning in 2017.

Higher interest rates, declining liquidity, and a rising US dollar make that debt more difficult to service or roll over, precipitating a loss of investor confidence, potentially triggering a feedback loop of asset liquidation and in the extreme, lasting economic impairment.  

The lesson of 2018 is of how fragile the global financial system remains despite the trillions of dollars deployed under central bank quantitative easing programs.  Half of the USD5 trillion investment grade bond universe is now rated BBB, just one notch above junk status. A sustained economic downturn or an adverse credit event has the potential to unleash an avalanche of corporate downgrades and forced selling that would affect all markets.  

Reserve Bank of India governor Urjit Patel was one of the first to raise the alarm over the unintended consequences of policy tightening by the Federal Reserve.  

Just over one year ago, in a June 3, 2018 Financial Times op-ed Patel warned of the negative impact created by a dollar shortage across the emerging market sectors and urged the Fed to back off on plans to shrink its balance sheet.  

He described the combination of balance sheet reduction and increased US treasury bond issuance (to finance tax cuts) as a “double whammy” threat that had essentially caused dollar funding in the sovereign debt markets to evaporate, sparking foreign capital outflows and leading to instability in currencies like the rupee.

The Fed listened.  As a result, they will cease drawing down their balance sheet this September.  And if prices in the futures market are any indication, the US could cut rates four times between now and the end of next year.

But is it too late and will it be enough?  Terms of trade are being reshuffled on a global basis, and the effect on growth from disruptions to supply chains is still in the early stages and most likely underestimated.  The risks ahead for India’s, and more broadly emerging nation’s, financial markets is that the extraordinary nature of these challenges falls beyond the control of not just the RBI but of all central banks, leaving India with one foot on shaky ground.

[The rupee and the Indian equity market are essentially the same trade right now as investors remain nervous over the entire emerging market sector.  The prospect for easier policy from the US Federal Reserve has taken some pressure off of the rupee and its currency peer group for now.]

“The views expressed by the author in this article are personal and do not reflect those of Connected to India.”