Dollar Liquidity: 2 Catalysts

By Lyn Alden Schwartzer:

The dollar has had a wild ride against other currencies lately due to heightened volatility surrounding the COVID-19 pandemic shutdown and the subsequent trade and cash flow disruptions around the globe, but it ultimately remains in a trading range with no clear direction.

This article provides an update about the dollar and overall liquidity, based on current conditions.

The direction of the dollar is of course important for institutional investors, but is also relevant to understand for retail investors because it plays a role in the direction of stock prices and other asset classes. It’s also an indirect measure of a deflationary/reflationary tug-of-war that is currently happening, which affects the relative performance of growth stocks vs value stocks, and U.S. stocks vs international stocks more broadly.

Back in early October 2019, I published an article called The Most Crowded Trade when the DXY dollar index was about 99, explaining why I am expecting a weaker dollar in 2020. I predicted that the Federal Reserve would begin expanding its balance sheet shortly by buying Treasury securities, meaning the U.S. would shift from a tight monetary policy to a loose monetary policy (relative to the rest of the world):

There are a few ways this can play out. The most likely outcome is that the Federal Reserve will begin expanding its balance sheet again by 2020 (or perhaps in this fourth quarter 2019) to relieve pressure from domestic balance sheets, which means that the Fed would essentially be monetizing U.S. government deficits.

When the article was written, the Fed was only doing repo operations, and was not yet permanently buying assets. A little over a week later in mid-October, the Federal Reserve announced that they will begin expanding their balance sheet to buy T-bills. Remember, this was far before any economic impacts related to COVID-19; it was due to a shortage of dollars in the financial system relative to the amount of T-bill supply that needed to be bought ($1 trillion federal deficits or 5% of GDP during an economic expansion), so the Federal Reserve became the biggest buyer of Treasuries via new dollar creation to buy T-bills through primary dealers.

Here’s the Fed’s holdings of Treasuries. To put it into perspective, the Fed accumulated more Treasuries over the past six months than the entire foreign sector has accumulated over the past six years.

Chart Source: St. Louis Fed

When discussing the possibility of a dollar spike prior to a longer-trend dollar correction in that article, I noted:

As far as I can tell, most of the dollar bulls who expect a much higher breakout in the dollar underestimate the damage that a strong dollar self-inflicts on the United States economy, which would then likely self-correct via a recession and major deficit monetization. The strong dollar reduces foreign corporate income and forces U.S. institutions to fund the U.S. government deficit, and after five years of doing this they are nearly tapped out and with flat dollar-denominated profits. Any major dollar breakout would likely be brief, self-correcting, and unpleasant.

Then in February and April 2020, I published a set of articles called The Global Bottleneck and The $40 Trillion Problem that outlined the global dollar shortage due to the ramifications of the global reserve status of the U.S. dollar.

The main point of those articles, particularly the April one, was that after years of U.S. trade deficits formed by having the global reserve currency, foreigners collected enough dollars and reinvested those significantly in U.S. assets, and now they collectively own $40 trillion in U.S. assets. However, they also have over $12 trillion in U.S. dollar-denominated debt. This is mostly owed between themselves rather than owed to the United States. For example, many emerging markets owe China debts that are denominated in U.S. dollars.

So, if there is a decline in trade or shortage in the availability of U.S. dollars to service the debts, the foreign sector can resort to selling U.S. assets, including U.S. Treasuries, in order to get dollars to service those debts. Unlike the Federal Reserve in the United States, the foreign sector can’t print U.S. dollars, even though they use dollars and have debts in dollars.

That is what happened in March. Foreigners sold over $250 billion in Treasuries as the dollar briefly spiked to nearly 103 on the DXY dollar index, and this in part contributed to the U.S. Treasury market becoming illiquid with spiking yields. The Federal Reserve repeatedly cited this problem in their press releases and meeting minutes, and began buying up to $75 billion per day in Treasuries at the peak to fix the issue (by far the fastest pace ever seen), and opened a variety of liquidity swap lines with foreign central banks to ensure they have enough dollars so that they don’t need to sell Treasuries to get dollars.

Here’s what the Federal Reserve said in their March 15 un-scheduled emergency meeting at the depths of the crisis:

In the Treasury market, following several consecutive days of deteriorating conditions, market participants reported an acute decline in market liquidity. A number of primary dealers found it especially difficult to make markets in off-the-run Treasury securities and reported that this segment of the market had ceased to function effectively. This disruption in intermediation was attributed, in part, to sales of off-the-run Treasury securities and flight-to-quality flows into the most liquid, on-the-run Treasury securities.

-March 15 FOMC Unscheduled Meeting Minutes

Here’s the Federal Reserve describing their actions for bailing out the Treasury market after the fact:

Treasury markets experienced extreme volatility in mid-March, and market liquidity became substantially impaired as investors sold large volumes of medium- and long-term Treasury securities. Following a period of extraordinarily rapid purchases of Treasury securities and agency MBS by the Federal Reserve, Treasury market liquidity gradually improved through the remainder of the intermeeting period, and Treasury yields became less volatile. Although market depth remained exceptionally low and bid-ask spreads for off-the-run securities and long-term on-the-run securities remained elevated, bid/ask spreads for short-term on-the-run securities fell close to levels seen earlier in the year.

-April 28-29 FOMC Regular Meeting Minutes

After that brief dollar spike in March, the dollar has had a consolidating and ultimately downward trend relative to other currencies. The question is, where does it go next?

I can’t answer that question for sure, but I can provide a few signposts to look for when analyzing it. Ultimately, I continue to view the dollar as headed down for the long run, but not without the possibility of another spike upward first, along with specific catalysts to look for to gauge the ongoing probability of that happening.

This is a chart of the DXY dollar index, which measures the strength of the dollar compared to a variety of foreign currencies such as the euro, yen, pound, and franc. The euro is by far the biggest currency in the comparison basket.

Chart Source: Koyfin

I’ve labeled six different time periods on that chart.

Time Period 1- The Federal Reserve was tightening monetary policy while the federal government was running large deficits. This was draining dollars from the system, which is temporarily dollar bullish. I became relatively dollar bearish in early October after the repo spike of September 2019 happened, and the dollar pivoted to the downside around that time.

Time Period 2- Due to an acute shortage of dollars available continue buying Treasuries, the repo lending market broke and the Federal Reserve became the primary buyer of Treasuries, and began expanding its balance sheet (creating new dollars) to buy Treasuries and provide repo lending. This added liquidity to the system and was dollar bearish, bringing the DXY dollar index from over 99 to nearly 96 within a few months.

Time Period 3- At the start of 2020, the Fed began trying to wind down repo lending operations while continuing to buy T-bills. This briefly resulted in a flat balance sheet, and therefore re-tightening dollar conditions which are bullish for the dollar. The DXY dollar index climbed over 3% to the 99-100 range. This was ultimately temporary; T-bill purchases would likely continue but repo lending would ultimately reach a bottom, meaning the balance sheet would likely begin expanding again within a couple months.

Time Period 4- However, before time period 3 could finish naturally, COVID-19 hit. Contrary to the idea of the dollar as a safe-haven trade, the dollar sold off incredibly sharply at first, from a DXY dollar index level of almost 100 to well under 95 in a three-week period. Investors sold dollars and bought yen, francs, and euros; economic regions with current account surpluses. Investors, however, also aggressively bought U.S. Treasuries and drove yields very low.

Time Period 5- Then, the dollar shortage became acute, with global trade sharply diminished. The Treasury-Eurodollar spread (aka TED spread) spiked, which indicates a dollar shortage in overseas markets, and the foreign sector had trouble getting dollars to service dollar-denominated debt. The dollar spiked from under 95 to nearly 103 on the DXY dollar index, and the foreign sector sold U.S. Treasuries to get dollars. This dollar spike in mid-March was a rare period for U.S. stocks and U.S. Treasuries to crash sharply in unison, and the Federal Reserve went into crisis mode to flood the system with trillions of dollars. This was the type of brief, self-correcting, and unpleasant dollar spike that I was concerned about potentially happening when I mentioned it back in October 2019, although I wouldn’t have guessed back then that a pandemic-related shutdown of global trade would have been the trigger.

Time Period 6- Due to foreigners selling off U.S. assets and the Treasury market “ceasing to function effectively” as the Federal Reserve described it it, the Federal Reserve created trillions of new dollars to buy Treasuries, mortgage-backed securities, and even corporate bonds, and provided liquidity swaps to foreign central banks to ensure that dollars got to the rest of the world, so they would stop selling Treasuries and other U.S. assets. This flood of liquidity has been dollar bearish, quickly bringing the DXY dollar index down from nearly 103 to briefly under 96, from which it has since bounced up from.

There are many reasons that dollar strength is relevant for U.S. and global financial markets, and even for the real economy, due to its role in global liquidity.

Historically, during strong dollar periods, major pivots in the dollar precede major pivots in economic growth. In other words, changes in global liquidity tend to precede changes in economic outcomes, rather than the other way around.

Perhaps more important for the reader is that sharp spikes in the dollar index tend to coincide with bottoms in the U.S. equity market (and many other global equity markets as well). If there is an acute global dollar shortage, the foreign sector sells dollar-denominated assets on net to get dollars, and similar effects happen domestically due to margin calls.

If we look back in 2008/2009, for example, the double dollar spikes coincided with the double bottoms in the U.S. total equity market, as measured by Wilshire:

Chart Source: St. Louis Fed

We saw a similar repeat of this in 2016, although it was milder because the U.S. managed to avoid a recession, and the economic trouble was more concentrated to the commodity and industrial sectors:

Chart Source: St. Louis Fed

And most recently, we saw a repeat of the inverse correlation in March of this year:

Chart Source: St. Louis Fed

As previously mentioned, a spread that has become relevant this year is the Treasury-Eurodollar spread (TED spread), which measures the rate differential between Eurodollars (offshore interbank dollar lending) and T-bills. A higher spread indicates that there is shortage of dollars in the offshore financial sector, whereas a lower spread indicates that there is plenty of dollar liquidity there.

If there is an offshore dollar shortage and the TED spread spikes, the Federal Reserve can perform liquidity swaps, which means they loan dollars to foreign central banks in exchange for receiving some of their foreign currency as collateral. The Fed and other central banks can roll these loans as needed, and foreign central banks can distribute dollars to areas in their country that need them to service dollar-denominated debts.

Back during the 2008/2009 crisis, the TED spread (and subsequently the dollar index) spiked to high levels, which was indicative of a shortage in dollars in offshore markets. The Fed responded by providing massive central bank liquidity swaps, which eventually relieved the shortage:

Chart Source: St. Louis Fed

Then, months after those liquidity swap lines were active and the TED spread was relieved, the dollar index was relieved to lower levels as well:

Chart Source: St. Louis Fed

In 2012, during the European Sovereign debt crisis and overall market turbulence around the world, the TED spread became elevated again and the Fed provided small liquidity swaps. There wasn’t a dollar spike at this time, nor any major recessions, so this mostly flew under the radar.

Chart Source: St. Louis Fed

In 2016, despite the spike in the dollar index that happened at the time, the TED spread only became slightly elevated, and the Fed did not have to provide any official liquidity swaps. There were many viable rumors at the time of a “Shanghai Accord”, or an off-the-books decision between nations including the United States to weaken the dollar and therefore increase global liquidity.

In 2020, we had basically a repeat of 2008. The TED spread and the dollar index spiked amid the global trade shutdown, and the Federal Reserve ramped up huge liquidity swaps, which brought the TED spread back down, and relieved the dollar index off of its highs.

Chart Source: St. Louis Fed

And the dollar has similarly eased off its peak:

Chart Source: St. Louis Fed

This 2020 version is still playing out; liquidity swap lines are still active and we don’t know yet if that was “the top” or if there is another leg later this year or early next year for them to deal with again. It would take a pretty big financial or geopolitical curve ball for that not to have been "the top" in liquidity problems, but we'll see.

Year-to-date with data through May, the U.S. Federal Reserve grew its balance sheet at a far faster pace than the Bank of Japan, European Central Bank, or People’s Bank of China.

Chart Source: Yardeni

Specifically, the BOJ and ECB increased their balance sheets by about 11-13% from the end of December 2019 through the end of May 2020 (mostly from March through May and ongoing), while the Federal Reserve increased its balance sheet by over 70% during that same time period.

We can also measure the central bank balance sheets as a percentage of GDP. By the end of 2019, the BOJ’s balance sheet was about 104% of Japan’s GDP, the ECB’s balance sheet was about 38% of the Euro Area’s GDP, and the Fed’s balance sheet was only about 19% of U.S. GDP. By the end of May 2020, this had increased to 116% for Japan (a 12% net gain), 43% for the Euro Area (a 5% net gain), and 33% for the United States (a 14% net gain). So, the U.S. started from the smallest base but is rising the fastest.

Many people like to look at it in absolute terms (i.e. “Japan has printed the most money”), but rate of change is what matters more for currency movements (i.e. “the United States is currently printing faster than the other majors”).

The dollar strengthened when the U.S. had the tightest monetary policy compared to other majors for much of the last 5-6 years, but ever since the September 2019 repo spike happened, and especially since COVID-19 happened, the United States has had the loosest monetary policy among the majors, and so the dollar has had a more neutral/bearish trend, except for the brief shortage-related spike that caused a sharp sell-off in the Treasury market and thus caused the Fed to loosen further and provide a multitude of central bank liquidity swaps to protect the Treasury market.

Rather than being locked away in reserves, a big chunk of QE found its way directly into the economy. This is because governments did so much fiscal spending to mitigate the impact from the pandemic shutdown, and that spending was largely financed by central banks creating currency to buy sovereign bonds. Unlike QE being primarily used to recapitalize central banks like in 2008-2014, this QE in 2020 was primarily to monetize fiscal spending.

As a result, broad money supply is up significantly. In the United States, people received $1,200 checks, $600/week in extra unemployment benefits on top of normal unemployment benefits, and small business loans that turn into grants under certain conditions. Most or all of this was financed by the Federal Reserve buying U.S. Treasuries through primary dealer banks as intermediaries, funded by new dollar creation.

U.S. broad money supply is growing at its fastest year-over-year pace in modern history:

Chart Source: St. Louis Fed

So far, broad money supply growth has mirrored balance sheet expansion. U.S. money supply is up about $3 trillion year-to-date, which is about the same amount that the Fed’s balance sheet increased by. The broad money supply of yen and euros are up in absolute and percentage terms too, but not anywhere near as much as the money supply of dollars. The Fed has been the most dovish so far in this crisis in terms of providing any and all liquidity that the market seems to need, because otherwise they face the prospect of the Treasury market ceasing to function effectively.

Personal income in the U.S. is up during this recession so far, rather than down. Stimulus payments by the government have offset loss of income for many people.

Here’s the year-over-year percent growth of personal income (an annualized rate), with the latest data point in April (reported in late May):

Chart Source: St. Louis Fed

During recessions, the growth rate of personal income goes down on a national level, and sometimes turns negative, as people lose jobs. It also turns down during economic slowdowns that don’t quite turn into recessions, like the economic slump of 2015-2016.

But so far, that level is up big in 2020, at the heart of a record-shattering job loss period as Congress provided helicopter checks and extra unemployment benefits. Many people kept their jobs and also received $1,200 checks, or lost their jobs but received unemployment checks that were as larger or in some cases larger than what they were paid while working.

We’re likely to see the ECB and BOJ continue increasing their balance sheets as more of their fiscal spending comes online, so the question is, what will happen in the United States? Will we continue to have the loosest monetary policy, or will we start to taper and for others to catch up?

In my view, there are two main catalysts to watch for the dollar, and they primarily revolve around fiscal policy.

First Catalyst: Free Money Runs Dry (Dollar Bullish)

A key time period to watch is August.

By the end of June, PPP loans “mature”. PPP loans to small businesses can turn into grants if small businesses that received them met certain criteria, like keeping most of their employees on payrolls through the end of June. Once July comes, they have more freedom to determine what employees they need or don’t need based on revenues and cash flows, without affecting their loan-to-grant conversions.

By the end of July, the $600/week that unemployed folks are receiving on top of normal unemployment (which vastly boosts unemployment income) comes to an end. Based on about 30 million unemployed people reporting continued jobless claims as of this writing (which includes the 10 million or so folks in the Pandemic Unemployment Assistance program on top of the 20+ million normal continued jobless claims), that’s perhaps $70-$80 billion per month in extra payments injected into the economy that may come to an end.

Congress is already discussing another round of fiscal spending, but they have differences between the parties on what to spend the money on and how much.

A big part of this V-shaped recovery in stocks has been due to so much fiscal spending to offset the economic damage. If August comes around and fiscal spending hasn’t passed, or comes in with small numbers, we could very well see another deflationary move, dollar increase, equity sell-off, and so forth. This could trigger a significant corporate solvency crisis as well, along with the risk of further civil unrest if free money is tapered away. It’s always harder to take that type of support away, than to provide it in the first place.

If they try to sharply taper fiscal stimulus, I would expect significant turbulence in the markets, and more likely than not, a rising dollar.

On the other hand, if the U.S. gets another round of stimulus, gets more dollars in the system, and keeps the party going for a while, it increases the odds that the flat-or-bearish USD trend remains intact. I would be somewhat surprised to not see another significant stimulus in the late summer, well prior to the election, but there is considerable uncertainty for how large it will be.

Second Catalyst: Treasury General Account (Dollar Bearish)

A fascinating number to watch in recent months has been the Treasury General Account. This is the U.S. government’s checking account at the New York Federal Reserve.

Prior to the 2008 crisis, this figure used to be very small. Post-crisis, they have generally kept more funds in there, and in recent years they have often aimed as high as having $400 billion on hand, which is a nice cash buffer that gives them flexibility during debt ceiling debates and so forth.

Right now it’s… over $1.5 trillion.

Chart Source: St. Louis Fed

According to Treasury press releases, they plan to end this fiscal year with $800 billion in the account, which is twice as their previous high level. The federal government’s fiscal year ends at the end of calendar year Q3, which is the the end of September 2020.

What this effectively means is that they have more than $700 billion in spending to do this summer without having to issue a big chunk of more Treasuries, just to get down to levels that are still double the previous all-time highs of $400 billion.

Another way to think about it is that this extra $700+ billion (the amount of the TGA that is over the $800 billion year-end target) represents a big portion of unspent fiscal stimulus, unspent Treasury issuance, and unspent recent Fed QE debt monetization of that Treasury issuance. This is a big pile of money sitting around available to spend with new stimulus if they pass it, shortly before a U.S. election. If spent, this could further boost dollar liquidity and further inch down the dollar relative to other major currencies.

This economic crisis has already brought forward what could have been the next few years of monetary and fiscal policy to within a span of several months, and I still think we’re in the early innings. The 2008 crisis resulted in 5+ years of major federal deficit spending to get back to the unemployment baseline that they started with, and this 2020 recession is likely to result in similar major deficits for 5+ years.

When analyzing relative currency strength, in my view the biggest variable has to do with the rate of change of ongoing balance sheet growth and broad money supply growth in the United States relative to the rest of the world.

My base case is that the U.S. will have more aggressive fiscal policy over the next several years than many other major countries and that it will be significantly financed by QE, meaning that the Fed’s balance sheet and the U.S. broad money supply will grow more quickly than peers and dollar liquidity will be relatively abundant. However, there will likely be reversal trends along the way from quarter to quarter and things can always change, so I’ll continue to monitor and measure these developments as they come.

See also Federal Realty Investment Trust: Good Upside For A Conservative REIT on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.