The strong dollar, the carry trade and market volatility

I have been meaning to write this post for a few days. And as the information comes in from Brazil, from China, from equity markets, it seems all the more compelling that this is indeed an important period in market and economic history. I would say the strong dollar is the genesis of a lot of this stuff and it is the unwind of multiple carry trades that is creating the market volatility. Some thoughts below

Back in September of last year, former UBS chief economist George Magnus proclaimed that this was the third great US dollar bull market that we were seeing. He saw this as cycles of “feast and famine” meaning that post-Bretton Woods US dollar bull and bear markets were of a fundamental importance to the global economy and asset markets alike.

I agree with this take, writing in December that, “while the US domestic economy is insulated from economic weakness abroad, giving the Fed room to manoeuvre, the result is a strong dollar. And a strong dollar is the genesis of multiple financial crisis in the fiat currency period.” What I meant to say here is that the US is a continental economy in which trade is a relatively low percentage of output. That makes what happens abroad of less economic significance to the US than the significance of what happens inside of the US to the rest of the world. This dichotomy, in part, can be the genesis of a fundamental shift in dollar strength that has massive implications for the world economy and global markets. When I talked about this in December, I noted at least four crises connected to major shifts in the strength of the US dollar : the LDC/Latam debt crisis, the Plaza Accord/Japanese bubble, and the Tequila and Asian crises.

As I put it then, the most important takeaway was that “a strong dollar is toxic for emerging markets because those markets do not have deep capital markets, US dollar denominated debt a tempting option for governments and corporates alike”. And what this means is that the carry trade gets unwound. We’re talking about over $9 trillion in off-shore US dollar lending, half of this in emerging markets. That is a huge slug of money and it is because this transmission channel is so deep that the emerging markets have run into crisis and market volatility has picked up.

The question then is this: how resilient are the emerging markets? And if they are not resilient, what are the transmission paths back into developed markets and global asset markets. First of all, the huge amounts of reserves that sovereign issuers have shields them from pain at the moment. That is an outgrowth of the pain of the Asian crisis when sovereigns were caught out short of US dollar reserves and ran aground as their currencies plummeted. This time, the debt is almost entirely corporate. And according to the BIS, the offshore US dollar corporate debt phenomenon is a sort of shadow banking operation. Here’s the FT:

While some companies in mature economies take a precautionary approach to debt, raising cash for a rainy day, the behaviour of emerging market borrowers does not fit the pattern, the data suggest.

In effect it looks like a corporate version of the “carry trade”, a common financial tactic of borrowing cheaply in one currency and investing the proceeds in another where interest rates are higher.

The paper suggests some cash is raised for financial, not commercial, reasons. By doing so companies become shadow banks, financial intermediaries moving dollars into local economies.

Think of this US dollar liquidity then as a increasing credit in the emerging markets, rather than in developed markets that were in a post-crisis deleveraging recovery with anemic credit growth. So zero rates and quantitative easing in the US did not necessarily mean credit growth in the US, instead it translated into credit growth in emerging markets via the carry trade. But now that the US has begun to tighten and the dollar has risen substantially, credit growth has become a credit squeeze and the carry trade is unwinding in a massive way.

In 2014, we got the fragile five economies of Turkey, Indonesia, India, Brazil and South Africa under attack during the post-taper tantrum credit squeeze. But that crisis faded and the beat went on. Eventually, however, the US dollar bull infected every corner of the EM universe. And when the slowing in China became perceptible this year, a second EM crisis was on us. Raoul Pal told me he believes the Chinese US dollar carry trade is the biggest in history, $3 trillion. And this is what is behind the market convulsions.

From a resiliency perspective, the question for emerging markets goes to contingent liabilities. For example, in April, I asked the question “How would markets deal with a Petrobras default?” My answer:

A reasonable worst case scenario is one in which Petrobras runs out of money and either has to be financed by the state government or default. This is where the issue of sovereign contingent liabilities come into play, despite the huge foreign reserves built up by these central banks. We saw the same issues build up in Russia, due to sanctions and the fall of the Ruble in 2014. I believe the risk is still with us for emerging markets as a whole, with Asian corporates and Brazil being particularly vulnerable. The $5.7 trillion of US dollar emerging market debt is split into $3.1 trillion in bank loans and $2.6 trillion in bonds. Asia is home to half of the offshore $9 trillion of US dollar funding.

So what happens then if the state cannot or will not intervene to prevent Petrobras from going down because of political constraints due to the corruption scandal? The first thing to recognize is that when you think of emerging market defaults, this would be on par with Russia in 1998 and larger than Argentina in 2001 given the enormous size of Petrobras, a firm that accounts for one-quarter of Brazil’s hard currency borrowing. There would be a massive ripple of contagion via derivatives given the CDS market. But then there are Petrobras’ own derivatives contracts, the terms of which we are not privy to.

Elsewhere in derivatives markets is the CDO market. Because Petrobras is so large, we should consider that Petrobras is a major constituent of many CDOs, where 55% of the market is now made up of collateralized leveraged loans, which are both illiquid and high yielding/higher risk. A Petrobras default could cause huge turmoil in this very large market.

I don’t think EM is as resilient as we think. Less than two months after I wrote this piece, though, Petrobras issued a $2.5bn 100-year US dollar bond at a yield of 8.45%. To me, that was crazy. Even crazier was the fact that there were $7bn of orders for this issue, investors lining up to buy a century’s worth of risk in a company whose equity asset value was declining from $300bn to well south of $100bn in a period in which oil prices had been cut in half.  Fast forward to yesterday and Petrobras is downgraded to junk after the sovereign was downgraded. And the equity is now down to $30bn. Default is a risk, as I wrote in April. And the fact that people are lining up to take on that risk for a full 100 years at 8.45% tells you that markets are not even remotely prepared for it.

The transmission path back to developed markets is not entirely clear to me quite yet. I see the carry trade unwind in Brazil and China as very important to global growth. But until we have a Petrobras-size credit event, I don’t see the transmission path to markets or the real economy in the US in particular. Speeding up of the interconnected and imminent market death in American shale oil – and the likely impact on US credit markets and capital expenditure – is the biggest transmission mechanism I can see at present.

So for now, we have a US dollar bull market which is negatively impacting the emerging markets. I believe the impact will become still more severe over time, in a negative way for those economies and markets. And this will create general market volatility. But the catalyst for true developed economy impact is not yet in place. The meltdown in shale is the closest we have to this and that event is coming later this year or early next year.

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