Friday, while many enjoyed the trip down memory lane reviewing the 2008 FOMC transcripts, I was focusing on the current price action in the bond market. There was an obvious bid for duration as the 30-year Treasury outperformed all day while the 5-year spent most of the day a tick in the red struggling to keep up with the long end of the curve. The 5-year Treasury is one of the most liquid and highly traded securities in the world,so when it is fading, the balance of the yield curve there is some serious pressure being applied.
One day's price action should not be extrapolated into a trend, but with apparently nothing going on this bid for duration was beyond curious. As I discussed last week, the long end of the curve should be rising as the Fed backs out of the market while the economy supposedly achieves escape velocity. Yet the long bond continues to stay in place, closing the third consecutive week at the 3.70% level.
Both bull and bear curve flattening is inherently disinflationary as investors lower the term premium that compensates them for inflation risk. A bear flattening curve typically occurs after the Fed has been easy and begins to raise interest rates. A bull flattening curve typically occurs after the Fed has been tight for too long and needs to lower interest rates.
But this time is different. At the zero bound, QE has taken the place of the Fed funds rate as the primary monetary policy tool. Unlike changes in interest rates, QE worked through inflating the dollar, which also happens to be the world's reserve currency. Unlike previous Fed monetary cycles where liquidity is injected into the financial system through US banks via Fed funds, QE injected liquidity directly, and much of it was exported outside the US borders.
Last week in a report titled "Pig in the Python: The EM Carry Trade Unwind," Bank of America Merrill Lynch's Hong Kong team explained how exported QE manifested in emerging market carry trades, and that the magnitude of the leverage is not accurately calculated because most of the leverage is being issued in US dollars outside respective borders (emphasis mine):
Most standard analysis on the balance of payments recognizes external debt as issued by residence, not by the nationality of the issuer. That is, if an Indian firm borrows USD debt from a foreign bank branch in Mumbai, that is counted in the BoP, but if it raises a USD bond in London, it is not... It makes a huge difference. For externally-issued bonds, USD1042bn has been raised by the nationality of the EM borrower since 2009, USD724bn by residence of the borrower -- a gap of USD318bn, or 44%.
Emerging market banks and corporates have gone on an international leverage binge, yet another carry trade, the third in 20 years... This time, it is increasingly nonequity: commercial banks and more importantly, the bond market – often undercounted in the BoP and external debt statistics that conventional analysis looks at.
…the EM external debt – from bond issuance and forex borrowing from banks – rose USD1.9tn during 3Q08-3013. We posit that this large rise was in part driven by the carry trade offered up by QE... The USD1.9tn rise in EM debt issuance is highly correlated to the Fed's balance sheet since late-2008.
So QE didn't do much to stimulate credit creation in the US, but the emerging markets took full advantage of the cheap USD cost of funds and they used these cheap dollars to finance a host of speculative activities. BAML concludes:
Of course, they could simply have used the borrowed forex proceeds offshore to make real investments overseas, or to hedge forex receivables. Our experience tells us to be suspect of this innocent use of funds: we believe EM entities execute carry trade opportunities with a ferocity that only becomes clear when the carry reverses.
Thus QE has not just created asset price inflation; it has created a massive short US dollar position. Global macro strategists GaveKal
in a February 7 report titled US Current Account and Vanishing Global Liquidity
explains the perils of what happens when this short dollar position gets stressed (emphasis mine):
In normal times, the financial flows that result from a US current account deficit are used by the private sector to trade and invest worldwide -- as such the US current account is the primary source of working capital that countries use to trade with each other. Put another way, this deficit is the only source of "earned" foreign exchange reserves.
FX Reserves Deposited at the Fed
...if the amounts generated by the US current account are insufficient to meet overseas nations' needs, then those economies will, as already outlined, be forced to either borrow dollars (not a long term solution), flog domestic assets or run down foreign exchange reserves. Hence, when I see central bank reserves deposited at the Fed falling, I know that we are getting close to a "black swan" event, as dumping these precious "savings" is, for any country, always a desperate last resort.
The stress in emerging markets has been documented by me and others since the tapering discount blew apart markets in the spring of last year. A couple of weeks ago in With Fed Taper; Rebalancing of Global Trade Set to Begin
I highlighted a similar point GaveKal is making above.
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.
US Current Account Vs. Fed Balance Sheet
With the Fed backing out of QE, this liquidity party is now over. However, I think because US risk assets have thus far been relatively immune to the emerging market stress, there has been a scoffing by US investors that this is some obscure problem in some strange faraway land. In this weekend's Financial Times
in an article titled Wall Street bulls shake off winter blues
, this risk apathy is epitomized by Morgan Stanley's
(NYSE:MS) Adam Parker.
"I just don't think the emerging markets matter as much," Adam Parker, US equity strategist at Morgan Stanley, says. "As long as you can dream that growth [in the US and China] is going to improve and that the Fed won't move the front-end of the [US Treasury] curve, we're going to keep going up."
Dream growth? I didn't know it could be so easy.
For those waiting for a correction, the results from corporate America suggest that is unlikely, says Mr Parker. "The market never goes down 10 per cent unless the fear of a corporate earnings recession is substantial."
Never? Whew, that's comforting.
Let's look at the numbers. According to FactSet
the corporate growth story is far from optimal. The bottom-line earnings number looks to be a robust 8.5% however when you look under the hood you see suspect internals with revenue growth a mere 0.8%. The financial sector leads earnings growth and is the biggest drag on revenue growth. When you exclude financials the earnings growth number falls to 5.4% while the revenue growth number rises to 2.2%. You can't make this stuff up.
This time last year, Parker, after turning from one of the most bearish strategists on the Street to the most bullish, said
his high S&P
(INDEXSP:.INX) target was predicated on the market's continued multiple expansion:
Why has the P/E expanded? Most likely, this reflects central banks' aggressive liquidity injections, which have translated into an increasing conviction among investors that major tail risks have been indefinitely removed.
So his rationale was that under QE, stocks rallied on multiple expansion and risk premium compression due to QE's ability to reduce tail risk. By that reasoning, now that QE is being removed, stocks will continue to rally because there is no fear of an earnings recession. This market hasn't cared about earnings in over a decade, however, so for earnings to carry the load seems like wishful thinking.
What the market does care about is liquidity, and liquidity that is levered via carry trades is very sensitive to moves in asset prices. With the Fed removing liquidity and leveraged assets in emerging markets, under pressure, levered liquidity evaporates exponentially. Combine this with a USD yield curve that is flashing a disinflationary bias, which could be indicative of leveraged assets being under pressure, and you might say that tail risk is rising.
Now back to the Fed transcripts. The financial crisis in 2008 didn't happen because borrowers quit paying their mortgages in 2006. The financial crisis was a run on the system. A system that was interconnected, levered long carry trades and short dollars.
In 2008 it was private lenders who removed the dollars by refusing to roll over money market instruments. Today it is the Fed that is removing dollars by reducing asset purchases. We have a remarkable juxtaposition whereby today's hindsight narrative is one of disbelief that the Fed failed to recognize the systemic implications of a pervasive short US dollar carry trade. Meanwhile investors whistling past the graveyard are gleefully long risk exposure while another pervasive short dollar carry trade is imploding yet again.
Does this emerging market stress mean US stocks will go down? I have no idea, but just because they haven't doesn't mean they won't. Stocks aren't rallying because of improving economic fundamentals or financial fundamentals. As Adam Parker says, they are rallying on multiple expansion due to reduced tail risk. The same tail risk that is predicated on the supply of dollars. The same tail risk that ignited the financial crisis. The same tail risk that is on the rise today.