Framework for trading the coming dollar liquidity crisis

For the past decade since the financial crisis, China has largely supplied incremental global liquidity. This is a fundamental change from previous decades where the US was the fulcrum. But, today the Chinese have realized they can no longer provide the same level of liquidity to fund growth given the rising debt levels in their economy. And so, the result is a global growth slowdown that will eventually lead to a shortage of dollars and, likely, a financial and political crisis.

This is a short framework for how to think about which macro pieces are important here in navigating investable outcomes.

Chinese goals

The headlines say that Chinese policymakers have struggled to turn around a rapidly weakening economy, with growth in 2018 at its lowest rate for 28 years. But, all signs are that Chinese policymakers want this growth deceleration simply because they recognize the need to deleverage. And so they are actively trying to organize a soft landing for the Chinese economy.

President Xi Jinping even said fairly directly last month that this is where things are headed, opining that China must be on guard against “black swan” risks while fending off “gray rhino” events as the economy slows. The focus, then, is not on growth per se, but, on a glide path during a growth deceleration without hiccups that produce a “black swan” or a gray rhino” – unforeseen events with extreme consequences or obvious yet ignored risks.

This is a problem as much for the external environment as for China itself, given that the incremental contribution of China to global growth has now surpassed the US. Countries dependent on external demand from China like Australia or Germany are going to be especially hard done by from this strategic shift.

And so, we are entering a period of synchronized slowing global growth as a result.

The US dollar funding market

Loans create deposits. This fact is now common knowledge after the Bank of England highlighted it in 2014. And what that means regarding the US dollar currency area, given the dollar’s reserve currency status, is that much of the global creation of money is done in US dollar terms outside of the US banking system. Effectively, the US Federal Reserve is the world’s central bank.

And so, when  incremental growth dissipates due to a strategic shift in China, we will see this show up as a slowing, and eventually reversal, in eurodollar loan growth. The same is true for other funding currencies like the Japanese yen and the Swiss franc. Eventually, this has to lead to a liquidity event where borrowers of US dollars (and yen and Swiss francs) are effectively short currency funding, bidding up the price of their funding currency in the process.

That’s where currency markets will end up. But before we get there, things may be quite a bit different. Right now, due to economic slowing, the Federal Reserve has joined the rest of the world in loosening policy. And that’s weakening the dollar. I expect dollar weakness to last right up until the credit cycle turns and liquidity dries up, at which point, there will be a big upturn in the US dollar, along with the yen and the Swiss franc.

Where’s Europe in this?

The weak link in the advanced world here will be Europe. And that’s not just Germany because of its reliance on external demand. But the whole of the eurozone is following the same strategy, with Euro Land moving from a roughly balanced net external position before the European sovereign debt crisis to a net surplus position. And this shift owes not to increased external demand for the eurozone periphery, but to internal devaluation and suppression of internal demand. So, as the global economy slows, the eurozone periphery will be hit hard. We see that in Italy already, with the country already in recession again.

Moreover, once the demand shortfalls begin in earnest, it will negatively impact individual countries’ fiscal balance. And that will trigger mandatory cuts under the stability and growth pact framework, sucking more demand out of those economies. So, I expect this to result in a contraction in credit, defaults and crisis – both in financial and political terms.

…And EM?

At the same time, the emerging markets will also struggle because of the increase in private debt and the over-reliance on US dollar funding. I am not as sanguine about rotating into EM as EM bulls like Jeremy Grantham, despite the relative value. And this is simply because the funding structure of EM says we should expect another leg down before an optimal entry point is clear. This is true as much for Asia as elsewhere, given the increased corporate debt in EM Asia.

Framework

So, the macro picture here then is of a synchronized global growth slowdown led by China. The US will look relatively good on a global basis, whereas Europe will founder due to poor macro pre-conditions and the fragility of the eurozone’s institutional architecture. Emerging markets will be the epicenter of the dollar, yen and Swiss franc funding crisis that results.

The questions here are: how quickly can policymakers recognize the threats and what will they do to mitigate worst case outcomes? The Chinese have already said they will do whatever it takes to prevent worst case scenarios from materializing. And so, I think there is relatively less upside in playing that outcome. On the other hand, I see the institutional rigidities of the eurozone giving Europe a big target on its back, with the financial system coming under stress as a result. The US has a n underbelly of excess corporate leverage and somewhat limited policy space. But the macro pre-conditions are better than they are in Europe.

That’s my framework for thinking about outcomes over the next 2 years. It doesn’t have to end in an all-out panic. Nevertheless, it’s not just a tail risk that it does end this way. I expect the European piece to begin to play out in early to mid-2019.