Monday 12 August 2019
Why the Fed has to cut 100bps, but will only do so after a market crash
I have previously argued that QE repatriation, which I thought would be driven by QT, is a new Plaza Accord that would put the Yen and probably the Euro into 2-3 year structural bull markets.
It seems we are now there, via a different driver. With USD Libor above the yields of Treasuries and other fixed income securities, financial and other investors are incentivised/ forced to take profits and it seems repatriation is going on. This is also causing the Euro to now rally in risk off days and the USD to sell off. That's the opposite of prior relationships and shows just how much the US has been dependent on external funding in this cycle and on an ongoing basis, given Trump's deficits.
You can clearly see the repatriation in the Yen. The Yen bottomed in Q4 as US 10 year yields peaked and has tracked the US 10 year lower (stronger Yen). Recently the US 10 yield going below USD Libor has accelerated both the Yen rally and the fall in yields; they seem to be reinforcing themselves on a reflexive basis.
In my opinion the Yen could go to 65 before it has any real valuation problem, but I expect that will take several years. It has until recently been one of the cheapest majors on a REER basis.
I also think the JPYCNY rate could go over 7.5c and perhaps over 8.5c later, which would represent a full unwind of Abenomics and a much more competitive CNY.
According to the headline Fed figure, US banking system excess reserves are $1.37Tn.
However JP Morgan, BaML and others have argued that true excess liquidity is now tight and that amongst other factors a few banks hold a lot of excess reserves, while others are struggling to fund themselves, such as primary dealers who are holding what seems to be an ever growing pile of >$200bn of TSYs.
To finance which they have added about $125bn of net repo financing since Trump cut taxes last year.
Into this mix we see the US Treasury increasing Treasury issuance significantly over Q3 and Euro and Japanese investors liquidating fixed income.
In summary then, we have catalysts for USD liquidity to tighten a lot in Q3 and for US investors who buy the Treasuries being sold to have to sell other assets to fund those purchases. To rectify this dynamic JP Morgan and BaML conclude that the Fed will have to restart OMO/ QE.
However that doesnt resolve the fact that US Libor is higher than TSY yields. To fix that the Fed will need to cut about 100bps, assuming the curve doesn't fall further before the Fed cuts.
However the Fed/ Powell have said they will only cut rates on a lagging basis to data/ markets. So they wont pre-empt any move. Instead financial conditions will have to tighten significantly and the fastest way for that to happen is equities and credit crash into September.
It goes without saying that both Trump and Xi have the geopolitical equivalent of 'sell buttons' that can be pressed at will.
This whole dynamic of liquidation causing market falls and then Fed rate cuts is hardly positive for the USD bulls aginast the major currencies, albeit the USD is likely to rally against EM FX particularly as countries like Brazil slide into recession and South Africa gets downgraded.