by Ambrose Evans-Pritchard
September 6, 2017
The US Treasury and the Federal Reserve are both poised to start draining liquidity from the financial system, threatening a bout of dollar scarcity and a potential shake-up of currency markets over coming months.
The twin-shift in policy is likely to tighten the availability of credit and send a strong impulse through Wall Street and global bourses, though whether it will be powerful enough to dampen frothy asset prices in the current exuberant mood is an open question.
“As we approach the fourth quarter, dollar scarcity could return as a theme. The upcoming tightening of US liquidity is not fully reflected in market pricing,” says Christin Tuxen and Jens Naervig Pedersen from Danske Bank.
They says the US Treasury has run down its cash balance sheet to almost zero this year as it nears the federal debt ceiling fixed by law. This has increased the US monetary base, which surged by a staggering 9% in the first quarter alone.
The Treasury has stated that it wishes to maintain a cash buffer of $500bn in normal times as a reserve to cover terrorist strikes, natural disasters, market shocks, or other emergencies. But as it builds the cash balance – by making a permanent deposit at the Fed – it automatically tightens monetary policy.
Assuming that the limit is raised this Autumn after a tense few weeks of brinkmanship and political skirmishing in Washington – likely, but far from certain – the US Treasury is expected to replenish the buffer rapidly. Danske estimates that this could drain $350bn of market liquidity over the following four months and set off a dollar rebound.
What makes the US Treasury actions doubly-potent this time is that the Fed is about to pull the trigger on ‘quantitative tightening’ (QT) at exactly the same time, taking the first steps to wind down its $4.4 trillion balance sheet after almost a decade of ultra-stimulus.
“This will not be a walk in the park,” says Danske Bank.
Tightening by the Treasury is a time-honored pattern following debt-ceiling episodes. After the last big showdown in September 2015 there was an abrupt monetary squeeze as the cash buffer rose, causing the dollar to rocket with a slight delay.
This dollar appreciation had all kinds of secondary effects. It set off a capital flight problem in China at a vulnerable moment; it aggravated the oil price crash; and it led to the sharp sell-off on global stock markets in early 2016. The S&P 500 index of equities fell 12%.
That mini-drama must be interpreted with care: ‘correlation is not causality’ – as the saying goes – and the circumstances are different today. Yet lack of dollar liquidity clearly played a central role in those events.
As for the Fed, it will start by selling $10bn of bond holdings each month – possibly as soon as this month – rising in stages to $50bn a month after a year.
“This will lead to a corresponding fall in US liquidity and completely alter the composition of high-quality liquid assets to be used in the calculation of banks’ liquidity coverage ratio,” says Danske Bank.
Nobody knows what will happen when the Fed unwinds quantitative easing. Nothing like this has ever been done by a major central bank in modern times. Top officials have tried to calm nerves by insisting that it will be as dull as “watching paint dry.”
But former Fed chief Ben Bernanke has warned against any such move, saying it would be safer to concentrate on raising interest rates first to create a safety margin for next downturn. The Fed should let the economy grow into the bloated balance sheet gradually.
Professor Danny Blanchflower, a former UK rate setter now at Dartmouth College, says it was a grave mistake to enter into these treacherous and uncharted waters. “They have no idea how to unwind it,” he says.
The implication of synchronized tightening by both the US Treasury and the Fed is that the dollar could begin to rally after sliding all year, contrary to the widespread view in the markets that the glory days of the US currency are over as the euro and the Chinese yuan take up the baton.
The Fed’s broad dollar index has fallen by 8% since January, chiefly because global investors have lost faith in President Donald Trump’s ability to deliver on tax reform and infrastructure stimulus, and have therefore marked down the pace of Fed rate rises.
It is typically the differential in interest rates across countries that drives exchange rate moves.
The dollar index tracked by traders (DXY) has fallen 11%. It has dropped through key levels of support against the euro, which has been on steroids over the summer as fund managers and currency traders lurch en masse from extreme pessimism to extreme optimism about the prospects for monetary union. Little has actually changed below the surface.
If there is a liquidity squeeze, the great unknown is what will happen to those emerging markets that have borrowed heavily in US dollars. Some $10 trillion of debt has been raised in US currency beyond America’s borders, leaving the global economy more sensitive to the US exchange rate and to US borrowing costs than at any time in post-War history.
The Bank of International Settlements says the dollar has become the barometer and the driving force of global risk appetite. It is the key to global asset prices.
When the dollar strengthens, banks in Asia and Europe are forced to curtail overseas lending through the complex effect of hedging contracts on the derivatives markets.
For now the global economy is firing on all cylinders. There is enough stimulus in the pipeline to keep growth humming well into next year.
Stock markets are another matter. They move to a different rhythm, and typically anticipate shifts in the economic cycle several months in advance.
A dollar surge could be the wild card that upsets a lot of assumptions. As the saying goes, never buck the Fed, and never buck the US Treasury either.