By now you have all heard of the looming “US dollar shortage.” We all know the stories about the massive emerging markets US dollar debt issuance that needs to be paid back with an ever appreciating dollar. Or we have heard the whispers about the lack of US dollars in the overseas Eurodollar market. Or even more scary, the rumours of how the Chinese banking system is starved for greenbacks, and there is no swap line big enough to satisfy the needed US dollar liquidity.
Although the US dollar has been rallying on news of the Trump economic stimulus plan, the rally has been exaggerated by hedge funds convinced the rising dollar has created a negative feedback loop where US dollar strength causes liabilities priced in US dollars to be more expensive, thus encouraging more debt to be paid down (credit destroyed), causing the US dollar to rise even further, creating a self reinforcing death spiral.
The short term demand for US dollars has gone through the roof as everyone is worried there won’t be enough to go around.
Ironic isn’t it? The same investors who labeled Yellen the Queen of Helicopter money are now convinced she will do nothing to alleviate this US dollar shortage. Whereas a couple of years ago they were worried about her leaving the spigots on too long, they are now convinced she will allow the global economy to dehydrate from a lack of US dollar liquidity.
In fact, they are betting she will make it worse.
Have a look at the speculative net positioning in the 3 month Eurodollar futures market (Eurodollar futures are based on the interest rate of the overseas market for US dollars):
Specs have never been more short. They are betting interest rates for 3 month US dollar overseas money will increase.
At this point you are probably saying so what? The Fed is on a tightening path, why shouldn’t the specs be leaning short?
But have a look at the five year note spec positioning:
Versus the 30 year T-bond spec positioning:
The specs are way more bearish on the front end of the curve versus the back. They are in essence betting the Fed will raise rates, and by so doing, will keep inflation under control.
They have no worries the Fed will err on being too easy and let inflation run wild. If they did, they wouldn’t be so short the front end, and would instead be leaning heavily on the long end.
This attitude is confirmed by the strange belief held by many market participants that Donald Trump wants to appoint two hawkish Federal Reserve Board Members. When I hear these sorts of comments, I almost spit up with an audible “are you shitting me?” During the election campaign Donald Trump criticized the Fed for being too easy. That was when he wasn’t in power. Now that he has the reins, Trump will be the furthest thing from a tight money guy. In fact, I suspect before his term is over, he will be complaining about the Fed not being easy enough, not the other way round.
The market is betting the Fed will raise rates too quickly, forcing the US economy back into a stop-and-go moribund low growth environment. Obviously it is more complicated than that, but if market participants thought the Federal Reserve would be slow to raise rates they would be selling US dollars, buying the short end and selling the long end. The exact opposite of what they are now betting on.
I must admit to being sympathetic about the “US dollar shortage” concept. I have been arguing for quite some time Yellen has been too tight, not the other way round. When I read the technical research about the problems in the eurodollar market, it all falls into place. The Fed does not understand (or does not care) about the US dollar’s role as the global financial system’s reserve currency. For the global economy to expand, there needs to be more US dollar credit being created, which is difficult as the Fed chomps on the bit to normalize policy.
Yet as usual, by the time everyone is hot and bothered about the US dollar shortage, the time to act on it has long past.
Speculators have already placed their bets heavily in the direction of the shortage getting worse. So not only do you have to be right about the problem, it will have to be worse than expected.
I don’t buy that Yellen will prove to be nearly as hawkish as the market expects. I concede she didn’t fully understand the global economy’s sensitivity to US dollar liquidity, but in heart of hearts, she is a labour economist. And although the headline unemployment numbers are improving, there is way more slack in the labour market than meets the eye.
The employment numbers are masking a huge underemployed working class. Yellen knows this. She will be loathe to raise rates too quickly while this massive portion of the population does not have jobs.
The FOMC does nothing quickly. Although over the past couple of years they have been too tight, that was in the previous environment of tight fiscal policy. Now that governments have finally realized the folly of fiscal austerity policies in a balance sheet constrained economy, the tide has shifted. With interest rates at abnormally low levels due to previous errors, rates will have to rise. The market is correct in anticipating higher rates. But the FOMC will be slow. They are after all a bunch of bureaucrats who still vividly remember the pain of 2008.
Almost every Central Banker in the world has stressed their willingness to allow inflation to run above target. So why bet against them? Why short the front end when they are telling you they will let the economy run hot?
The lack of US dollar credit creation over the past half dozen years has, in part, been from regulators clamping down on banks and other credit creating institutions. The 2008 credit crisis showed these entities could not be trusted, so the government decided to tightly regulate their activities. It is no surprise the velocity of money has been falling. But I suspect this trend has turned. At the very least, I don’t think it will get any worse. Regulatory tightness has probably hit its peak, and in fact, with Trump’s victory, is set to turn the other way.
And as for the US dollar, I wonder if we are not witnessing the end of its role as the reserve currency. After all, it has had a good run, but the problems resulting from Bernanke’s overly easy policies and Yellen’s too tight policies have made it abundantly clear that having the global financial system so closely tied to one independent nation’s monetary policy is not so wise.
I am still bearish on the US dollar, and I would rather bet on the Fed not tightening as quickly as the market anticipates rather than the other way round. The idea that Trump’s new Federal Reserve appointments will shift the FOMC boards’ balance towards tight monetary policies is laughable. During a true economic upturn, the Fed will be slow to raise rates. They always have been, and they always will be. I still contend that before this whole nightmare is over, the yield curve will become record steep. We will look back and laugh that we were ever worried about a “US dollar shortage.”
Thanks for reading,