Too Much Cash – Why Abundant Liquidity May Hurt The Markets
Excess liquidity caused by low-interest rates is backfiring. Banks are hurriedly flooding the FED with cash. Are investors ignoring the warning signs?
Alive Once Again
With negativity coming from all corners, Mr. Market would like to make you believe that the USD Index is heading back to 75. However, after bouncing above 90 on May 26, the greenback remains undervalued and likely has plenty of room to run. Case in point: I highlighted on May 25/26 that the U.S. Federal Reserve’s (FED) daily reverse repo transactions are mirroring the volatility that we witnessed in December 2015. And while investors have ignored the unsettling behavior, with sold repos’ value spiking above $450 billion on May 26, the USD Index may be sensing that something is amiss.
Please see below:
A reverse repurchase agreement (repo) occurs when an institution offloads cash to the FED in exchange for a Treasury security (on overnight or short-term basis). And with U.S. financial institutions currently flooded with excess liquidity, they’re shipping cash to the FED at an alarming rate.
The green line above tracks the daily reverse repo transactions executed by the FED, while the red line above tracks the federal funds rate. Moreover, notice what happened the last time reverse repos moved above 400 billion? If you focus your attention on the red line, you can see that after the $400 billion level was breached in December 2015, the FED’s rate-hike cycle began. Thus, with current inflation dwarfing 2015 levels and U.S. banks practically throwing cash at the FED, is this time really different?
To that point, while it may not be visible on the surface, global central banks are already tightening financial conditions. Following in the footsteps of the Bank of Canada (BOC), the Reserve Bank of New Zealand (RBNZ) announced on May 26 that “we believe it is appropriate to return to our long-standing practice of publishing an OCR projection.” And while the RBNZ labeled its forecast as “conditional” and subject to “the economic outlook,” it’s clear that we’re past the point of peak liquidity.
Please see below:
To explain, the blue line above tracks the RBNZ’s Official Cash Rate (OCR). If you analyze the right side of the chart, you can see that the central bank is already projecting liftoff by mid-2022. However, with most central banks initially expecting to hold off until sometime in 2023, if rampant inflation persists, another revision could happen sooner rather than later.
Shadow Rates
Case in point: “shadow rates” signal that a major shift is already underway. To explain, economists normally use the federal funds rate to construct their economic models. However, after the initiation of quantitative easing (QE) sent some overnight lending rates below zero (like the European Central Bank’s), shadow rates became a substitute for the federal funds rate. For example, when Jing Cynthia Wu and Fan Dora Xia created the metric, the relationship meant that when the FED increased its asset purchases by 1%, the shadow rate decreased by 0.0183%. More importantly, though, with the script now flipped, reduced liquidity is leading to a rise in global shadow rates.
Please see below:
To explain, the chart above tracks the rolling one-year change across various economies’ GDP-weighted shadow rates. If you analyze the right side of the chart, not only are all regions moving higher, but some have already moved into positive territory. Moreover, with central bankers akin to private-market investors, when one animal moves the herd often follows.
As further evidence, while emerging market currencies continue to elicit strength versus the U.S. dollar, real money flows signal that a sharp reversal could be forthcoming.
Please see below:
Source: IIF
To explain, the red and blue bars above track the real money debt and equity flows into emerging markets (excluding China). If you analyze the right side of the chart, you can see that total flows have turned negative (the black line) and equity flows (the blue bars) remain extremely negative. More importantly, though, when similar shifts occurred, the USD Index rallied from roughly 78 to 85 in 2013, from roughly 88 to north of 100 in 2015, from roughly 92 to north of 102 in 2016 and from roughly 88 to north of 97 in 2018. For context, I’m excluding the coronavirus-induced spike in 2020 because the sharp drop in real money flows is a material outlier.
What’s more, while inflationary pressures stoke fears of the greenback’s demise – based on the premise that the FED will print the dollar into oblivion – for one, the FED is likely to reduce liquidity in the coming months. Two, it’s important to remember that narratives often foster weakness in the U.S. dollar. For example, data from Morgan Stanley reveals that when the U.S. Consumer Price Index (CPI) outperforms the rest of the world, the USD Index often suffers mightily.
Please see below:
To explain, the blue line above tracks the U.S.-world CPI-spread, while the gold line above tracks the inverted year-over-year (YoY) percentage change in the USD Index. For context, inverted means that the latter’s scale is flipped upside down and that a rising gold line represents a falling USD Index, while a falling gold line represents a rising USD Index. If you analyze the relationship, you can see that when the U.S.-world CPI-spread rises, the USD Index often heads in the opposite direction.
The Euro – A Commodity-Linked Currency in Disguise
However, it’s important to remember that reflation is a boon for commodities and – in turn – commodity-linked currencies. To explain, with the Canadian dollar catching a bid during inflationary environments, rising oil prices can weigh on the USD Index. Likewise, while the euro is not considered a commodity-linked currency, the MSCI Europe Index – which represents roughly 85% of developed-market European equities – influences financials at 16.26%, industrials at 14.67%, consumer staples at 12.74%, and materials at 8.41%.
Please see below:
Source: MSCI
Conversely, the S&P 500 influences financials at 11.82% industrials at 8.83%, consumer staples at 6.11% and materials at 2.82%. The key takeaway? With European bourses highly leveraged to sectors that benefit from reflation, the euro is essentially a commodity-linked currency in disguise. Thus, with investors positioning for commodities Renaissance, the euro has been a significant beneficiary. And with inflation expectations often the bearer of bad news for the USD Index, the greenback has been on the defensive in recent weeks.
Please see below:
To explain, when inflation expectations rise, notice how the U.S. dollar, the Japanese yen, and to a lesser extent, the Swiss franc (risk-off currencies) suffer the most? Conversely, when reflation is universally projected, the euro, the Canadian dollar and the pound sterling are often strong performers.
However, when expectations ease and investors are left to deal with actual inflation, notice how the roles often reverse?
The U.S. 3-Month Treasury Bill and the Core PCE Index
In addition, with the Personal Consumption Expenditures (PCE) Index scheduled for release on May 28, another sizzling print could be on the horizon.
The green line above tracks the year-over-year (YoY) percentage change in the Commodity Producer Price Index (PPI), while the red line above tracks the YoY percentage change in the headline PCE Index (which includes the inflationary effects of food and energy). If you analyze the right side of the chart, you can see that a material gap is clearly visible. And while the headline PCE Index tends to undershoot the commodity PPI, reconnecting with the green line implies a headline PCE Index of roughly 5.50%. For context, the last time the PCE Index jumped above 5% was November 1990.
More importantly, though, when the spread between the U.S. 3-month Treasury Bill and the core PCE Index (which excludes the inflationary effects of food and energy) is positive or turns extremely negative, the USD Index is often a major beneficiary.
Please see below:
To explain, the blue bars above depict the quarterly performance of the USD Index when the spread between the U.S. 3-month Treasury Bill and the core PCE Index ranges between 6% and below -2%. As you should expect, the more positive the spread, the stronger the USD Index. However, if you analyze the left side of the chart, you can see that when the spread turns deeply negative, the USD Index – likely driven by safe-haven demand due to inflationary uncertainty – often rallies by 2%. Thus, with the commodity PPI signaling that the headline PCE Index should move meaningfully higher, the USD Index could receive some near-term support.
Finally, with the European Central Bank (ECB) holding its next monetary policy meeting on Jun. 10, the EUR/USD remains in Neverland.
Please see below
Weighing four scenarios, Vanda Research believes that a 65% chance (combined) of a delay in normalization or a slight reduction in the ECB’s weekly PEPP purchases will result in a 2% or 1% decline in the EUR/USD. Conversely, no dovish pushback (25%) or a hawkish policy mistake (10%) are expected to result in a flat ratio or a 1% rally in the EUR/USD.
However, with the Eurozone slipping back into recession in Q1 and inflation (released on May 19) up by only 1.60% YoY in April (and still below the ECB’s 2% target), the reading is paltry relative to the sizzle that we’re witnessing in the U.S.
Please see below:
To that point, ECB President Christine Lagarde said the following on May 21:
Source: Reuters
The bottom line?
If the FED resists tapering when the headline CPI is up by 4.15% YoY, is the ECB likely to do so with annual inflation rising by only 1.60%?
In conclusion, the USD Index recorded a meaningful bounce on May 26 and the FED’s reverse repo debacle may have already ruffled a few feathers. With excess liquidity becoming a hot potato that no one wants to hold, the overabundance is doing more harm than good. And with investors largely ignoring the signs of stress, as the old saying goes, ignorance is bliss. However, with the ground shifting below our feet, a reversal of fortunes is likely to occur in the coming months. And with the USD Index and the U.S. 10-Year Treasury yield topping the list of major beneficiaries, it’s only a matter of time before the PMs’ inaction turns into a negative reaction.
Disclaimer: All essays, research and information found on the Website represent the analyses and opinions of Mr. Radomski and Sunshine Profits' associates only. As such, it may prove wrong ...
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