In last week's markets, most pundits and strategists were focused on the 2013 Q4 GDP report and corporate earnings, but the market itself continued to focus on the future implications of the Fed's withdrawal of quantitative easing and its impact on the value of the dollar. It's quickly becoming obvious that the only release that matters going forward is not economic statistics but rather the Fed's weekly H.4.1
report on factors affecting reserve balances -- namely, the reserves held in custody at the Fed for foreign official accounts. As I noted last week in Your Portfolio's Fate Is Llinked to the US Dollar
, since the Fed announced tapering on December 18, 2013, FX reserves have been falling -- and falling fast.
FX Reserves Held in Custody
I first began monitoring FX reserves held at the Fed back in 2008 when reading a hedge fund pitch book that outlined a strategy aimed at short peripheral European sovereign debt. The hedge fund was Corriente Advisors; it was run by Mark Hart, who was teaming with international economic research advisors GaveKal
. The chart that caught my eye stated simply, "When FX reserves decline YoY, we usually have a financial crisis." The chart tracked year-over-year growth in FX reserves held at the Fed and indicated that the reserves dropped below zero in 1980, during the Latin American debt crisis, in 1990, during the savings and loan crisis, and in 1998, during the Asian/Russia/LTCM crises. Their thesis proved to be correct, and to my knowledge, they were the first investors positioned for what would become the European debt crisis.
On Friday, Sid Verma
of Euromoney ran an article
quoting a recent piece by GaveKal on current emerging market stress. It explained why this raises global systemic risk (emphasis mine):
The dollar is the world's reserve currency, which means the US is the only country in the world which has no foreign trade constraint. However, as we reviewed in our recent book (see Too Different For Comfort), this also means that the US current account deficit needs to grow if global trade is to expand. Indeed, if the US starts to export fewer dollars, then someone, somewhere will find he is unable to finance his trade. The US current account deficit is the monetary base of world trade, and a reduction in the US current account deficit is thus equivalent to a massive monetary tightening for the rest of the world. It is for this last reason that we spend so much time monitoring the growth of central bank reserves held at the Fed; for as long as these are expanding, there are few reasons to fear a hiccup in the global trade architecture. However, as soon as central bank reserves start to shrink, then countries running large current account deficits and/or large budget deficits may find pushing more debt through the system challenging. Excluding China, reserves at the Fed are contracting in real terms.
US Current Account Vs. Fed Balance Sheet
Between 2003 and 2007 the US consumption bubble was responsible for the current account deficit, which exported excess liquidity. When consumption collapsed in 2008 the US current account deficit began to narrow, but the Fed stepped in with QE; this acted as de facto US consumption and offset this current account contraction.
I wrote the following on April 22 in Gold, Interest Rates and the Great USD Short Unwind
The US consumption bubble has been the engine behind global capital flows, and the machine works in a certain way. You can think of the global market as one giant balance sheet. Our deficit is their surplus. Our spending is their income. Our liability is their asset. That's all simple. What's more complex is how the capital flow reverses and what it means for currencies, commodity prices, interest rates, and risk premiums.
This capital flow reversal is what we are witnessing today, and I think, when you juxtapose the current reaction in the bond market with the reaction last spring, you can gain a better understanding of the dynamics at play. This is a key distinction to understanding how this plays out in market prices.
The short USD carry trade that pervaded under QE was present in many assets, from gold to mortgages to emerging market credit. All of these carry trades depended on an inflated dollar that produced negative real interest rates. When tapering was first floated last year, there was an immediate re-pricing of US dollars and real interest rates. The Fed's inflation target commitment was being called into question and so, too, was its negative real interest rate regime. This re-pricing of negative real rates forced carry trades to de-lever and unwind.
The carry trade unwind could be seen in the relationship between real rates, eurodollar futures, and EM credit. I explained the following back on June 22 in Bernanke's Misfired Shot Heard 'Round the World
Positions that are long carry trades financed in USD predicated on the Fed's negative interest rate regime are in effect long eurodollars (short the floating rate) by virtue of their financing cost. When eurodollar prices decline, implied LIBOR rates rise, and vice versa. This carry trade relationship can be seen in the correlation between real rates, eurodollars, and a popular carry trade investment such as Brazilian bonds.
When the Fed announced at the December 18, 2013 FOMC meeting that tapering would commence in January, the QE carry had already been blown to pieces. It is highly unlikely these trades were reengaged only months after they were blown up, so I think to characterize the current market dislocations as "risk-off" carry-trade unwinding is a mistake. There is a different dynamic at play, and this can be seen in the much different reaction in US interest rates.
When the QE carry trade was being liquidated, mortgage-backed securities were one of the prime casualties, and the chain reaction of the negative convexity embedded in these securities could be seen across the interest rate complex. Treasuries weren't being sold due to taper fears; they were being sold because highly leveraged MBS positions were massively extending. As MBSs extend in duration in a rising rate environment, MBS holders sold Treasuries to hedge this duration extension.
Now that tapering has commenced, the market has already positioned and re-priced the MBSs that were being tapered. On December 10, 2013, before the Fed tapered, I made this case in Bond Market Trading Is Already Discounting the Fed Taper
, suggesting that, despite the Fed pulling back, MBSs offered investors a very attractive risk/reward in a rising rate environment and the ability to reinvest amortizing principal into higher coupons, because the convexity blow-up risk had been removed. I suggested that as rates rose, mortgage supply would likely decline.
MBS 30-Year Vs. UST 10-Year
Despite the Fed reducing purchases, both Treasuries and MBSs have performed well. The excuse you are hearing for falling rates is that they were caused by a short-covering rally ignited by a flight-to-quality bid due to emerging market carry-trade liquidations. I am skeptical of this explanation. I think interest rates are responding to a lack of demand for credit at higher rates. Each time the 10-year hit 3% we saw a significant decline in mortgage origination, and I think this is indicative of a threshold the market has found where economic activity is impacted. In other words, interest rates are falling because of a drop in the supply of credit.
While the initial market reaction was the re-pricing of positions, the current market reaction is more about a re-pricing of economics. As I noted above, first it was a US consumption bubble that exported the dollars that fed global trade, then QE stepped in to provide liquidity -- in effect, subsidizing US consumption. The 2008 financial crisis was as much about a rebalancing of the US consumption-led current account imbalance. While the US consumer has adjusted by reducing consumption, QE prevented prices from adjusting. Now, with the Fed pulling liquidity that manufactured demand, foreign currencies must fall to a level that equals real US demand.
The Fed's QE program delayed the inevitable global trade rebalancing, but now that the Fed is pulling liquidity, the rebalancing is about to ensue. The drop in FX reserves and currencies re-pricing is a product of this rebalancing. This is not about a financial trade; it's about economic trade, and it's not clear how much price needs to adjust to fix this imbalance. Currencies and interest rates are both seeking equilibrium, and both will eventually find it. When currency prices rebalance to reflect supply and demand, interest rates will follow suit.