Friday afternoon, with stock prices melting and investors struggling to make sense of the carnage in emerging market currencies, Wall Street's bond dealer strategists were hard at it publishing reports previewing next week’s FOMC meeting. Across my Bloomberg terminal the headlines crossed as follows:
15:12:43 Fed to Taper Again by $10b at Next Meeting: Nomura
15:18:45 Fed to Taper by $10b, Has Little Reason to Change Outlook: DB
15:26:02 Fed to 'Deliver More of Same' at Next Meeting: Morgan Stanley
15:44:41 Fed to Drop Monthly Pace of Purchases to $65b From $75b: BofAML
16:13:21 Fed Taper Is 'on Track', Expect $10b Reduction in QE: Jefferies
Brilliant! Do institutional fixed income investors really need for the dealer community to tell them the Fed is going to do what it said it was going to do? Telling us what the market already knows is not analysis. How about instead, what are the implications? How does this impact my portfolio? We need to know how market prices are going to discount the removal of liquidity.
This focus on the amount of purchases epitomizes the pervasive misunderstanding of how QE impacts the market. Since QE first began, Wall Street has increasingly relied on the Fed to tell it what is going to happen to interest rates based on Fed operations. The thought being that interest rates are lower than they otherwise would be if the Fed weren’t buying, and thus will rise dependent on how many bonds the Fed buys or doesn’t buy. The fact is that these strategies that rely on Fed guidance have been repeatedly annihilated because the Street has misinterpreted the most important market influence of QE.
Wall Street has been obsessing over tapering since last spring, yet no one has been able to tell us what it actually means for the market. The true impact of the Fed's removal of stimulus has been brewing for nearly a year, yet the whole time Wall Street strategists have been focused on the wrong market. QE is not about the level of nominal interest rates, it’s about excess liquidity of US dollars and the resulting inflation discount embedded in real interest rates and risk premiums. QE positions are, in short, dollar-financed carry trades, either outright explicitly or implicitly through exposure, leveraging excess liquidity and long a rising inflation discount.
Emerging markets were one of the prime beneficiaries of QE-induced excess liquidity, and the carry trades in these assets were predicated on US negative real interest rates and the Fed's commitment to its inflation target. When the Fed first floated the idea of tapering purchases last spring, inflation was well below the stated 2% target. The market saw this policy shift as a de-commitment to the inflation target that was producing negative real interest rates, and as real rates started to rise, the dollar strengthened and short dollar carry trades came under pressure.
Real Rates Vs. Brazilian Real
On April 22, 2013, as much of the financial community was focused on what the taper meant for the bond market, I recognized the more important implications. In Gold, Interest Rates, and the Great USD Short Unwind
, I cited the risk in the currency markets:
Over the past couple of months two emerging market experts have been sounding the alarm about the recent currency market volatility and consequences of a strengthening US dollar. Andy Xie and George Magnus are two of the most well-respected authorities on emerging markets, and the recent US dollar rally has no doubt triggered some concerns due to previous cycles of dollar strength.
Andy Xie, formerly of Morgan Stanley, wrote The Consequences of a Strong Dollar
citing a potential crisis in emerging markets:
"When the dollar changes direction, so does liquidity. The virtuous cycle on the way up becomes a vicious one on the way down. The emerging economies already suffer inflation. The liquidity outflow leads to currency depreciation, which worsens inflation."
Mangus wrote an article in the FT
titled Rising Dollar Marks Big Investment Shift
"The US dollar should be expected to trend higher against most leading currencies, and put industrial commodities and emerging market currencies and local debt under pressure."
The QE emerging market exposure could be seen by observing the decline in USD FX reserves held at the Fed as a percent of total USD reserves. I noticed there was a marked shift that coincided with negative real rates in 2011 that suggested these dollars were being invested elsewhere:
…you will notice that since the 2009 peak the share reserves getting deposited back at the Fed has been in decline with a steep drop beginning in August 2011. This is a major change in trend from what has been in place over the past decade that is indicative of a capital flow reallocation.
I believe this larger reduction custody holdings is indicative of a similar short USD carry trade into emerging markets.
At the time the emerging market carry trade risk was not appreciated, but it became my main focus. On June 17 of last year, I wrote the following in The QE Carry Trade Is Imploding Right Under Everyone’s Noses
It’s happening right under everyone’s noses, but they can’t see it because they don’t understand how QE impacts market prices. They are focused on the flow of QE and not the discount. It’s not the flow of purchases that affects risk assets, it’s the inflation discount embedded in the yield curve. The US economy and capital markets have been reliant on the Fed successfully engineering a negative real interest rate regime. By reneging on its commitment to inflation, the negative real rate regime is imploding -- and with it, the QE carry trade it engineered.
Of course the Fed backed off tapering, the markets settled down, and a crisis was averted, but the risk had been exposed. The markets knew an exit from QE was inevitable and the imbalances would continue to adjust. What was previously the unwinding of a trade driven by the re-pricing of a lower US inflation premium and stronger US dollar manifested in deteriorating emerging market economic fundamentals with rising inflation and falling exports. This further weakened the currencies in a vicious negative feedback loop, just as Xie had described. Now that the Fed is removing dollars from the system, emerging markets are increasingly vulnerable. This is the situation markets faced last week with the devaluation of the Argentine peso.
Since the Fed announced it would commence tapering QE at the December 18, 2013 FOMC meeting, FX reserves held at the Fed has dropped by $35 billion, from $3.338 trillion to $3.345 trillion. This suggests that carry trade positions are de-levering. We saw a similar reduction in June when the QE emerging market rebalancing process was ignited, only this time the actual supply of dollars is being reduced, potentially intensifying the deleveraging.
FX Reserves Held in Custodial Accounts at the Fed
With the Fed poised to continue reducing QE we should continue to see these reserves fall, putting further stress on emerging market currencies and economies. However, markets don’t tend to wait around for fundamentals to affect prices, so it’s conceivable that emerging market currencies discount the entire removal of QE long before it is ended.
Under the Nomura preview of next week’s Fed meeting cited above, Nomura notes "recent market volatility appears to be a result of developments in emerging markets, not potential changes in Fed policy.” Is that so? Well, Nomura may be correct that the Fed stays the course as it continues to wind down the program, but it is naïve to suggest market volatility is not related to Fed policy. In fact, US investors need to realize that risk asset prices are not simply reacting to emerging market currencies; risk asset prices and emerging market currencies are one in the same.
Most strategists are focused on fundamental growth metrics such as earnings and economic data but I tend to focus on what is discounted in market prices. At the beginning of this year I said the dollar/yen was the single most important price to watch in 2014
due to the influence on the US inflation discount embedded in asset prices. Year-to-date it has been obvious that the relationship between USDJPY and US risk assets is positively correlated as the emerging market turmoil has unfolded.
USDJPY Vs. S&P 500
At this stage of the liquidity cycle the market doesn’t care about earnings growth and economic data. The most important market metric is the price of the world’s reserve currency, the US dollar. The flight to the Japanese yen amid emerging market risk reduction and bull steepening of the US yield curve is telling you that the market is very sensitive to tightening monetary and financial conditions manifested in the price of the US dollar. The market is also telling you the Fed can’t remove excess liquidity of the US dollar without serious consequence. And perhaps most of all, the market is telling you that the fate of your portfolio is in the hands of foreign exchange values of the US dollar.