Do Central Banks Need A Plumber?

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Equity & Cross Asset Strategy

Paul Mylchreest Email: [email protected] Tel: +44 20 7716 8257

16th September 2015

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Do Central Banks Need a Plumber?

Eurodollar - “Global Fed Funds rate”, weaponisation and emerging

liquidity shortage

We acknowledge that the financial system’s “plumbing” is not a subject that equity investors

are usually prepared to immerse themselves in, but it has left them “behind the curve” on

more than one occasion.

Historically, problems in financial markets have arisen in the wholesale money (e.g. LIBOR,

repo) and/or forex markets, before spilling over into other parts of the system. There are

stresses in both and it would be unwise to dismiss them without in-depth evaluation.

Our analysis suggests that there is an emerging Eurodollar liquidity shortage - which extends

into wholesale and shadow banking markets - and is exacerbated by currency/maturity mis-

match. Eurodollars are dollar deposits held in offshore accounts outside the US.

Regulatory change and Fed policy (QE 2/QE 3) contributed to the tightness in Eurodollar

liquidity, leading to a huge inflow of dollars (US$1.0 trillion) on the part of foreign banks from

offshore Eurodollar markets into domestic US money markets in 2011-14. The recent reversal

suggests that foreign banks might be trying to shore up Eurodollar operations.


Company. Risk Warning: Investments in Equities, CFDs, Futures, Options, Derivatives and Foreign Exchange can fluctuate in value, investors should therefore be aware that they may not realise the initial amount invested, and indeed may incur additional liabilities. These Investments may entail above average financial

risk of loss, and investors should therefore carefully consider whether their financial circumstances and investment experience permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints

either in the United Kingdom or elsewhere. © 2014 ADM Investor Services International Limited 2014.

Equity & Cross Asset Strategy Paul Mylchreest Email: [email protected] Tel: +44 20 7716 8257

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It is looking increasingly like the Eurodollar is taking on a role akin to a “Global Fed Funds

rate.” Investors may have underestimated the degree to which a rising dollar transmits tight-

er monetary policy across an already misfiring global economy, especially when it is carrying

US$10 trillion (+70% since 2008) in offshore Eurodollar debt.

From a Chinese (especially) and EM standpoint in particular, it is becoming increasingly clear

that the dollar has been “weaponised.” While the Fed is using existing bilateral agreements

to expand much-needed dollar swaps to other DM central banks (likely including the Bank of

England on a covert basis...for HSBC or Standard Chartered we wonder?), the lack of a dollar

swap arrangement with the PBoC is a glaring omission.

We believe that the Chinese sell-off in foreign exchange reserves and US Treasuries has been

more to do with providing wholesale Eurodollar liquidity to its banking system, rather than

supporting the peg per se. This is harming stability and risks stoking a deterioration in rela-

tions between China and the US over the “dollar issue.”

Besides rapid transmission of US monetary policy to the rest of the world, Fed tightening is

complicated by the changed mechanics of implementing a rate increase, now that the Fed

Funds route is ineffective. The proposed new mechanism (Overnight Reverse Repo) is more

deeply integrated into the shadow banking system and might have adverse “knock-on”

effects to the “plumbing” as we explain.

The financial system is considerably more fragile than most commentators (and central

banks) are prepared to acknowledge. The biggest test for the “plumbing” lies ahead of us.

Our cautious stance towards equities highlighted in the 6 July 2015 report – titled rather long-

windedly “S&P500: technical indicator which called the 2000 & 2007 peaks gives first sell sig-

nal for current bull market in Equities” remains in place - as does our preference for defensive

positioning in sectors and stocks.

It is beyond the scope of this report, but sectors which could be at risk include (obviously) Banks – any escalation of problems in the “plumbing” is not priced in – along with Capital Goods and Autos.






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Contents

Introduction – it’s all about the “plumbing” 4

Eurodollars in 2007-08 9

Eurodollar flows since the crisis 13

Mid-2014: Eurodollar liquidity tide starts to ebb and the world changes 21

Eurodollar liquidity shortage becomes more apparent 31

China – caught in the squeeze 44

Fed policy – now complicated by shadow banking 52

Financialism and defensive stance on Equities 58






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Introduction – it’s all about the “plumbing”

The longer we’ve analysed financial markets, the more we’ve realised the importance of picking up

nuances coming from the “plumbing” in the financial system as early as possible.

In “Replumbing our Financial System: Uneven Progress”, Darrell Duffie of Stanford University com-

mented.

“Plumbing” is a common metaphor for institutional elements of the financial system that are fixed in the short run and enable flows of credit, capital, and financial risk. This institutional structure in-cludes some big ‘valves and pipes’ that connect central banks, dealer banks, money-market funds, major institutional investors, repo clearing banks, over-the-counter (OTC) derivatives central clearing parties, and exchanges. The connectors include lending facilities offered by central banks to each other and to dealer banks, triparty repo and clearing agreements, OTC derivatives master swap agreements, prime-brokerage agreements, and settlement systems” Looking back at the emergence of previous problems, they usually began in wholesale money markets

(e.g. LIBOR, repo, etc.) and/or forex markets before spilling over into other parts of the financial sys-

tem. Currently stresses are emerging in both.

In today’s markets, the consensus view has been that staggeringly heavy-handed central bank inter-

vention – including the US$10 trillion of additional credit creation - would not have unintended conse-

quences.

Source: ADMISI, Bloomberg

However, our contention is that after seven years of extreme intervention, the “plumbing” in the sys-

tem is becoming stressed.






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The initial signs of stress emerged in early 2014 with the unexpected weakness in the Chinese Yuan.

While its relevance was glossed over at the time, the stress started to become more obvious in the mid-

dle of 2014. We don’t think that it’s overstating the situation, as we argue in the report, to say that the

world changed from that period onwards and hasn’t changed back (yet anyway).

The end of June last year coincided with the beginning of the strong upward move in the US dollar and the subsequent breakout of the US dollar from a wedge which had been 30 years in the making. Source: ADMISI, Bloomberg

When we say “dollar”, we also mean “Eurodollar”, i.e. offshore dollars.

The US dollar stands at the centre of the financial system, given its dominance in trade and its reserve

currency status.

If we are correct, the US dollar is acting like a quasi “Global Fed Funds rate.”

This reflects the link between the dollar exchange rate and,

The transmission of US monetary policy to the rest of the world;

The 70% expansion of offshore Eurodollar debt to more than US$10 trillion since 2008;

Global economic growth; Liquidity in wholesale money markets and shadow banking; Financial stability; and (potentially) US/China economic relations.






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Dollars, dollars everywhere but…

As far as we can tell, there is an emerging shortage - essentially a “run” - in dollar liquidity which is

focused on Eurodollars.

We believe that the main reason that EM central banks, notably the PBoC, are resorting to selling

forex reserves and US Treasuries is to provide wholesale dollar liquidity to their respective banking

systems (and helping to address issues of maturity mismatch).

The Fed is extending dollar swaps with other central banks (almost certainly the BoE) which may be

alleviating the liquidity shortage somwhat in DM economies. However, the omission of EM central

banks, especially the PBoC, could be a serious miscalculation.

The global economy is credit (debt) driven - making global growth dependent on the provision of in-

cremental credit.

In the US, total debt (including the US$4.5 trillion on the Fed’s balance sheet) has reached US$64.0

trillion. The “law of (very) big numbers” is kicking in, which is leading to a structurally lower level of

nominal GDP growth. Indeed, the current level has corresponded with most of the recessions of the

last (more than) 50 years.


In China, like many others, we have serious doubts about the GDP statistics, but the rate of credit

growth, according to its broadest measure, has slowed substantially. It is now the lowest on record.






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An alternative way of looking at dollar liquidity supplied by the banking system is the volume of out-

standing derivatives held by US banks - which has been declining since 2013.

Source: OCC

In a credit driven economy, the nexus for transmitting “credit” into “growth” is a combination of:

The banking (including shadow banking) system’s balance sheet on a global basis; and

The day-to-day and month-to-month attitude of Portfolio Managers - given the growing per-

centage of credit raised in global bond markets.

Both are pro-cyclical which makes it risky to dismiss signs of a liquidity squeeze in the world’s major

currency and other factors (e.g. Basle III Leverage Ratio) which could pressurise balance sheets and in-

vestment attitudes across the financial system.

It’s been noted time and time again, that credit markets are smarter than equity markets. It’s early

days but we continue to track the flow of capital from riskier to safer assets across the credit complex.






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We can illustrate this using some of the large credit ETFs. Investment Grade Corporate (LQD) is outper-

foming High Yield (HYG).


And the long Treasury ETF (TLT) is outperforming Investment Grade Corporate (LQD).


We believe that the biggest test for the post-crisis financial system probably lies ahead of us, not be-

hind us (e.g. with the Eurozone debt crisis).






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Eurodollars in 2007-08

The functioning of the wholesale dollar market, which is effectively the heart of the world’s dollar-

based financial system, broke down on 9 August 2007 after BNP Paribas stopped redemptions on three

investment funds. That date marked the start of a scramble for dollar liquidity - especially Eurodollar

liquidity – which continued for more than eighteen months.

According to the FRBNY.

“The financial crisis that began in August 2007 disrupted U.S. dollar funding markets not only in the

United States but also overseas.”

The chart below perfectly illustrates how dollar liquidity bifurcated into what were effectively two sep-

arate wholesale dollar money markets.

London: LIBOR – Eurodollars; and

New York: Fed Funds – domestic dollars


With Fed support, dollar liquidity was plentiful in New York, while it was much tighter in Europe

(especially London) and elsewhere. In essence, the bifurcation of the dollar resulted from a credit

crunch in which domestic US money markets had access to Fed liquidity while Eurodollar markets did

not.






This was Zero Hedge’s Tyler Durden on the subject with our emphasis.

“this systemic dollar shortage was primarily the result of imbalanced FX funding at the

global commercial banks, arising from first Japanese, and then European banks' abuse of

a USD-denominated asset-liability mismatch, in which the dollar being the funding cur-

rency of choice, resulted in a massive matched synthetic ‘Dollar short’ on the books of

commercial bank desks around the globe”

The synthetic dollar short is now far larger- in excess of US$10 trillion – as discussed below. However,

we wanted to review what happened in 2007-08 even though current events are unfolding differently

thus far.

Back to 2007…and the very short-term funding nature of wholesale money and shadow banking

(mostly overnight or three months) markets led to problems in rolling over wholesaale dollar funding

outside the US. This prompted the run on Eurodollars and 3-month LIBOR moving to a significant

premium to Fed Funds.

Less than two years earlier, in October 2005, the New York Fed had issued a report “Money Market

Integration” which proved to be catastrophically inaccurate. It concluded.

“The two core components of the unsecured overnight bank funding market - the market for federal funds and the market for Eurodollars - are well integrated…From the viewpoint of policy design and analysis of the transmission of monetary policy, our results suggest that it makes little difference that the Federal Reserve targets only rates in the federal funds market, and does not in-clude trades executed in the larger Eurodollar market into its target.” In 2007, as the Eurodollar shortage intensified, the players which were most depenedent on short-term

Eurodollar funding were European banks. In its report, “The Financial Crisis and US Cross-Border Finan-

cial Flows”, the US Treasury commented that.

“When ABCP markets froze in the fall of 2007, European banks not only lost a source of new funding, but also needed to pay off the commercial paper and medium-term notes maturing throughout late 2007 and early 2008 that could not be rolled over in the market. Because many of the assets backing the commercial paper were illiquid, European banks needed other sources of U.S. dollars.” Today, we suspect that it’s banks operating in the EM economies, especially China, Hong Kong and Bra-zil, which are beginning to feel the most pressure in dollar funding.

An important lesson from the 2007-08 Great Financial Crisis was that there are effectively two “inventories” of dollar credit – one which is domestic US and one which is offshore, i.e. Eurodollars. Eurodollars are basically short-term obligations/deposits for dollar payment which are held at banks outside the US – avoiding US banking regulation and formal reserve requirements. In most cases, Euro-dollars are generally used to finance longer-term loans and securities, so there are often critical maturi-ty (and currency) mismatches.






To quote the BIS (from Working Paper 483 – “Global dollar credit: links to US monetary policy and lever-age” from January 2015). “There is only one federal funds rate and only one dollar Libor, but there are two stocks of dollar debt

responding in very different fashion to these interest rates. From a time series perspective, the off-

shore aggregate has behaved quite differently from its larger US aggregate, not least since the global

financial crisis”

The (Euro) dollar shortage and flow of dollars from New York to London was visible in the monthly

Treasury International Capital data. Note in particular the downward spikes, i.e. net dollar outflows, in

August 2007 and end-2008/start-2009.


Keep this chart in mind as we’ll show an up-to-date version below which implies that the tightness in

Eurodollar liquidity has returned.

Responding to the situation, the Fed stepped in with dollar swaps with foreign central banks beginning

in December 2007. Here is the FRBNY again.

“To address funding pressures internationally, the Federal Reserve introduced a system of reciprocal

currency arrangements, or ‘swap lines,’ with other central banks.”

This led to the short-term reversals in dollar outflows in late 2007 and the larger one at the end of 2008

– which can be seen in the above chart.






According to the US Treasury…

“Through much of the crisis, banks located in the United States played a primary role in funding dol-

lar needs abroad. During the height of the crisis in the fall of 2008, however, foreign central banks

provided dollars, drawn from their swap lines with the Federal Reserve, to foreign banks directly.”

…when the Fed’s dollar swaps peaked at more than half a trillion.

“the Federal Reserve dramatically increased the availability of dollars to foreign central banks through liquidity swap facilities. Outstanding amounts drawn on the swap lines reached…a peak of $554 billion at the end of December 2008. More than three-fourths of these funds were drawn by central banks in Europe. Because of the swap lines, the foreign banks that had been borrowing heavi-ly from their U.S. offices were able to obtain dollars directly from their own central banks. In re-sponse, the U.S. offices of many of those foreign banks were able to decrease their lending position to their parents, receiving a flow of funds back into the United States between September and De-cember of 2008.” From our research, we believe that the Fed has started to extend new dollar swaps to DM central banks – but not EM (which is significant). Before we address that, let’s look at Eurodollar flows since the crisis.






Eurodollar flows since the crisis

There are effectively two inventories of dollar credit/debt as outlined above, one which is domestic and the other which is offshore, i.e. Eurodollars. These two dollar inventories are inter-linked and effectively in competition with each other, given the different investment opportunities/rates and regulatory frameworks overseas compared with the US. The functioning of both the domestic and Eurodollar credit inventories are dependent on the efficient

performance of several wholesale money and shadow banking markets including Fed Funds (domestic

US), LIBOR (Eurodollars), repo, currency swaps and, in times of stress, the provision of dollars by central

banks.

Below we show how in recent years banks have moved huge volumes of dollars from offshore Euro-

dollar markets into domestic US money markets. This has been a response to regulatory change in

the US and Fed policy (QE2, QE3 and IOER). This has contributed to the shortage of Eurodollar liquidi-

ty. Since mid-2014, this flow started to reverse – which seems to reflect measures on the part of

banks to shore up their Eurodollar funding needs.

The analysis will first consider flows relating to US branches of foreign banks followed by US-chartered

banks and then the aggregate of both categories.

At the peak in late 2008, US branches of foreign banks were raising almost US$600bn in domestic US

wholesale money markets and transferring them into overseas Eurodollar markets in order to accumu-

late dollar assets (e.g. securities and loans) – a “round trip” of sorts. On the other side of the crisis (e.g.

2009-10), the volume of dollars supplied into Eurodollar markets from the US by foreign banks was low-

er, but still substantial, at around US$400bn.







Then “something” major happened (in a regulatory sense) going into 2011 which led to a dramatic change in the balance sheets of US branches of foreign banks. In April 2011, the FDIC assessment base (tax) on banks was widened from Deposits to Assets less Tan-gible Shareholders’ Equity. This applied to US chartered banks only and not US branches of foreign banks. The change had a major impact on flows of dollars in wholesale money markets. The increased cost burden to US chartered banks was recovered via lower wholesale funding costs, e.g. 3-month LIBOR fell by 6-7 basis points and repo rates fell by 10-15 basis points during February-May 2011. US branches of foreign banks, which were unaffected by the FDIC change, were better placed than their US counterparts to earn the “free profit” on the arbitrage between wholesale funding costs and 25 ba-sis point interest paid by the Federal Reserve on excess reserves (IOER). And bank reserves were in the process of receiving a large boost…thanks to the Fed. This was why US branches of foreign banks were disproportionately active in the Fed’s US$600bn QE2 programme, which was coincident with the FDIC assessment change. And notice how the next enor-mous surge in dollars flowing from overseas to domestic US occurred with the implementation of the much bigger QE3 (over US$1.6 trillion) in November 2012. So US branches of foreign banks “flipped” from being providers of US$400bn of funding into overseas Eurodollar markets at the beginning of 2011 to sucking in US$600bn of funding from Eurodollar mar-kets into their US operations by mid/late-2014. This represented an enormous swing in flow of approximately US$1.0 trillion in favour of domestic US money markets versus offshore Eurodollar markets. It’s not surprising that these capital flows led to significant changes in the respective balance sheets of foreign branches of US banks and their domestic counterparts. These changes included: The relative balance between funding via wholesale money markets versus deposits; The relative participation in domestic US money markets; and The buildup of excess reserves (held at the Fed) on the asset side of their balance sheets as a re-

sult of QE. In July 2014, the US Office of Financial Research published a paper “Shadow Banking: The Money View” by Zoltan Pozsar. While it specifically compares the period from Q2 2007 to Q3 2013, it still shows the near US$1.0trn shift in dollar funding (detailed above) for US branches of foreign banks – compare the yellow bars (GDF = “Global Dollar Funding”) at the two dates.






Source: Office of Financial Research

The gold bar in the assets category shows the dramatic impact of QE on the balance sheets of foreign banks operating in the US. The report makes this comment on dollar/Eurodollar flows. “Segment [1] shows that…the volume of global (or interoffice) money dealing by these branches went from raising $400 billion in the U.S. money market and lending it to headquarters globally in order to fund Eurodollar lending, to raising over $500 billion in Eurodollar markets and funnelling (sic) these back to the United States to fund reserves at the Federal Reserve.” And this one on the increase in participation in US wholesale markets by foreign banks: “Segment [2] shows that over the same period the volume of domestic money dealing by the New York branches of foreign banks rose from just under $300 billion to nearly $1.5 trillion, or from 20 percent to 65 percent of total assets.” If we examine the recent data on dollar flows in the banking system, the chart below shows that the flow of (Euro) dollars back to the US peaked during the first ten months of 2014. Beginning in Novem-ber 2014, there was a sudden reversal in this longstanding trend, which has since remained in place.






Source: ADMISI, Bloomberg Why the US$300bn - currently still over US$200bn - sudden reversal in late 2014? This looks like a defensive move, possibly to cover Eurodollar funding needs outside the US. Now let’s contrast US branches of foreign banks with dollar flows for US-chartered banks. US banks did the opposite to foreign banks, but on a smaller scale. US banks began repaying all of their net wholesale (Eurodollar) funding following the crisis period of late 2008. This process accelerated with the FDIC assessment change in 2011. Source: ADMISI, Bloomberg






These dollar flows can be seen in the roughly US$270bn swing during 2008-10 and additional US$450bn swing during 2011-13. In aggregate, therefore, US banks reversed their dollar funding by around US$720bn from net Eurodollar funding of their US operations of roughly US$620bn to a position of sup-plying a net US$100bn or so from the US into overseas Eurodollar operations. Since the beginning of 2013, the chart shows a renewed reversal of about US$200bn around the net zero point. US banks have shifted from a net US$100bn of domestic US funding for Eurodollar usage to utilizing US$100bn of Eurodollar funding domestically. Moving on to domestic US banks and here is the balance sheet comparison between Q2 2007 and Q3 2013. Source: Office of Financial Research The report backs up our earlier comments about US banks’ reduction in Eurodollar funding (yellow bar). “On net, U.S. banks raised about $400 billion of dollar funding in Eurodollar markets globally during the second quarter of 2007, less than 5 percent of total assets (see yellow rectangle on the liability side of the chart). This amount has fallen to marginal amounts since then.” The other major change for US banks was a far greater reliance on deposits versus all forms of whole-sale funding on the liability side of their balance sheets – the latter having declined to negligible levels. On the subject of wholesale funding of bank balance sheets, it’s noteworthy that the FDIC assessment change and QE led to a situation where US banks have minimal participation in domestic wholesale funding markets. In contrast, US branches of foreign banks are now the dominant players, by far.






It’s hard to imagine that this isn’t making the Federal Reserve nervous about the transmission of chang-es in monetary policy going forward. Now let’s look at the aggregate dollar flows of foreign and domestic US banks. While the dollar flows of foreign and domestic banks have generally been in opposite directions, there has been an overwhelming net flow of (Euro) dollars into the US. During 2011-14, the aggregated flows of both groups of banks are summarized in the following chart which shows a roughly US$800bn net inflow of dollars from offshore Eurodollar markets into the US. Source: ADMISI, Bloomberg The aggregate flow clearly breaks down into three periods. US$450bn during the first half of 2011 - helped by the anticipation and implementation of the

FDIC assessment change and the Fed’s QE2; A US$350bn reversal during mid-2011 to end-2012 – which was between Fed QE programmes

and also reflected the large scale withdrawal of US banks from accessing funding from domestic money markets (and switching to deposits); and

US$700bn flow during 2013-14 as QE3 was implemented. As we showed, foreign banks have accounted for almost all of this capital flow as the BIS explained: “In other words, dollar funding flowed into the US through non-US headquartered banks’ balance sheets. Far from funding offshore dollar loans, interbank flows competed with such loans for dollar funding.”






It’s worth emphasizing that last point made in the BIS paper that (Euro) dollar flows into the US have competed with the funding of offshore Eurodollar loans…which has contributed to the run on Eurodol-lar liquidity. Following on from this, we find it very interesting that there was a sudden US$300bn (and still over US$200bn) reversal during very late 2014 to the first few days of 2015. Source: ADMISI, Bloomberg Foreign banks were suddenly repatriating dollars back to their Eurodollar operations. Why might that be? Was it just down to the end of QE3? We don’t think so. It’s not as though the Fed’s IOER was suddenly reduced. As we said earlier, we think that it was a defensive move on the part of foreign banks. In our opinion, it likely reflected the tightening in Eurodollar liquidity and a sudden need to shore up Eurodollar funding in overseas operations. It seems that the issue of dollar liquidity is more serious than most people realise. We could be wrong, but it looks to us as though there’s been a run on Eurodollar liquidity and one that has been at least as severe as on three occasions as 2007-08 based on the Treasury International Capital (TIC) measure of capital flows.






The three occasions were: The beginning of 2014 - just prior to initial Yuan devaluation (see below); Mid-2014 – when so many economic indicators changed direction and the dollar began its major

rise; and End-2014 – when foreign banks suddenly moved about US300bn overseas from US money mar-

kets.






Mid-2014: Eurodollar liquidity tide starts to ebb and the world changes

The world changed in mid-2014, but the initial “tremor” in terms of tightening dollar liquity was the

PBOC’s unexpected devaluation of the Yuan versus the dollar in February 2014. Between early-

February/late-April 2014, the Yuan/Dollar rate rose 3.9% from 6.025 to 6.258.


Back then, the PBOC’s action was subject to much debate. Many commentators ascribed it to slowing

economic growth and the need to boost exports This should sound familiar vis-à-vis 2015.

The more savvy pointed to the need to change the view that the Yuan was a one-way trade, which was

leading to a build up in the short dollar/long Yuan carry trade. These fears are coming home to roost.

Other commentators also noted the authorities’ desire to rein in the huge distortions and rampant

growth in China’s shadow banking system. This included loans collateralised with commodities (e.g.

copper) and high-yielding Wealth Management Products (WMPs) following the default, and subse-

quent opaque (state-backed?) bailout, of the US$500m “Credit Equals Gold No.1” product in January

2014.

Then there were one or two, like the FT’s Izabella Kaminska, who connected all of the above - the

weaker Yuan, carry trade and shadow banking - with dollar liquidity. From her article, “The Curious Inci-

dent of the PBOC in the USDCNY market” with our emphasis.

“But one other explanation is that outstanding USD shorts (a la the China RMB carry trade, which

loosely involves Chinese companies borrowing USD via Hong Kong against all sorts of collateral, con-

verting it into CNH, reinvesting it domestically in high-yielding CNY instruments, and waiting for CNY

to appreciate) are unravelling on their own accord. It is a shortage of USD liquidity, in other words,

which is encouraging the liquidation of CNY instruments and their respective conversion into CNH

and then USD”






Basically, Chinese banks - no doubt with the approval of the PBoC - bid more aggressively for (Euro)

dollars in wholesale funding markets which weakened the Yuan.

The beginning of 2014 saw the bottoming out in Overnight LIBOR, i.e. the cost of borrowing Eurodol-

lars overnight. It surged in late 2014 when Eurodollar liquidity tightened considerably, continuing to

rise even after the FOMC signaled that an imminent rate rise would be delayed on 18 March 2015.


Although this initial tremor was quickly forgotten, it was followed in mid-2014 (as we mentioned

above) by the beginning of the upward move in the dollar in terms of the DXY.







The start of this move coincided with a series of warning signs across a range of financial market and

economic indicators – giving it greater significance in our opinion.

For example, there was a general spike in currency volatility.

Source: ADMISI, Bloomberg We saw a low in the MOVE Index (Merrill Option Volatility Estimate), which gauges volatility in the Treasury market. Source: ADMISI, Bloomberg






And a low in the VIX.

Source: ADMISI, Bloomberg Rates on junk bonds bottomed and began a sharp rise.







There was the high in the Global Manufacturing PMI.

Source: ADMISI, Bloomberg We had the start of the huge fall in crude oil and the low in WTI volatility, before the subsequent spike.

Source: ADMISI, Bloomberg Something else occurred in mid-2014, which escaped comment at the time, but suggested emerging

liquidity strains in wholesale dollar markets. The concept of dollar liquidity reaches deeply into the

realm of shadow banking both in the US and overseas, especially in key financial centres like London

and China/Hong Kong.






Within shadow banking, we watch the repo market more closely than any other – it was repo that led to the failure of Lehman, Bear Stearns and MF. In the US alone, the repo market is approximately US$4.6 trillion – the majority of which is overnight. It was described as “the silently beating heart of the market” by the US Treasury and Advisory Com-mittee. It is the nexus for collateralised lending, wholesale funding, leverage and short-selling on the part of banks, institutional investors, money market funds and hedge funds. It’s worth emphasising for non-credit/money market investors that this market. Is at the heart of the financial “plumbing”; It is systemically critical to the functioning of the banking system and securities markets; It was central to market failure in the 2008 crisis; and The majority of the US$4.6 trillion of funding is of the SHORTEST POSSIBLE DURATION, i.e. over-

night, and this aspect is clearly insane and should be dismantled. It has not been reformed despite the Fed’s tacit understanding of the risks (see below). In the repo market, collateral (e.g. Treasury and MBS securities) behaves like “high-powered currency.”

The middle of 2014 marked the start of a trend of more frequent spikes in Treasury Fails-to-Deliver in

the repo market.







This is something we take seriously given repo fails indicate collateral shortage, which is akin to block-ages in the “pipes”. The major contributor to this latest round of collateral shortages is actually the Federal Reserve. It is an unintended consequence of the QE programmes which “silo” vast amounts of “high quality” (e.g. Treasury and MBS) collateral on the Fed’s balance sheet. This severely damages the availability of these securities for repo purposes and, therefore, liquidity in the repo market. Few people realise that we would almost certainly have had a crisis in the repo market already – proba-bly beginning in 2Q 2014 - if it hadn’t been for the Fed rapidly stepping up its Overnight Reverse Repo programme (ON RRP). This began piloting in very small size in September 2013 and is currently capped at US$300bn. The main reason given for the ON RRP was that it would be critical for exiting ZIRP - but that was only

half of the story. The ON RRP was also needed to supply high quality collateral “silo-ed” by the Federal

Reserve’s QE back to the repo market. As the chart below shows, this has even exceeded the US$300bn

cap at times.

Source: ADMISI, Bloomberg Bill Dudley of the FRBNY acknowledged its role in addressing the collateral shortage when he stated that the ON RRP would also, “increase the availability of a risk-free asset, satisfying the demand when the appetite for safe assets increases.” The next chart shows that the trend in overnight repo rates since September 2012 (QE3 announce-

ment) – using a 20-day moving average - on Treasury collateral have been steadily rising since February

2014 (which coincided with the original devaluation of the Yuan).






Source: ADMISI, Bloomberg Without the smoothing effect of the 20-day M.A., you can see how volatility in repo rates has increased markedly since late-2014. In our opinion, this is suggestive of increasing stress being felt in the “plumbing.”







The Fed knows understands the risk in the repo market. Indeed, Janet Yellen specifically identified it in a speech, “Regulatory Landscapes: A US Perspective”, on 2 June 2013 (with our emphasis). “A major source of unaddressed risk emanates from the large volume of short-term securities financ-ing transactions - repos, reverse repos, securities borrowing and lending transactions, and margin loans–engaged in by broker-dealers, money market funds, hedge funds, and other shadow banks. Regulatory reform mostly passed over these transactions, I suspect, because securities financing transactions appear safe from a micro-prudential perspective. But securities financing transactions, particularly large matched books of securities financing transactions, create sizable macro-prudential risks, including large negative externalities from dealer defaults and from asset fire sales. The ex-isting bank and broker-dealer regulatory regimes have not been designed to materially mitigate these systemic risks.” She said that more than two years ago…and nearly five years after Lehman…and the much-needed re-form has not been undertaken. There was another warning sign last October. On 15 October 2014, we had the “flash crash” in US Treasury yields. 10-year Treasury yields fell an incredible 34bp and rebounded a similar magnitude in what was described as a “seven standard deviation move.” With so many investors positioned on the short side for a Treasury sell-off and broker-dealers in balance sheet contraction mode, the sudden spike in prices led to a rapid withdrawal of liquidity in the world’s most liquid bond market. In his November 2014 essay, “October Treasury ‘Crash’ Shines a Light on a Witless Fed”, Jeff Snider of Alhambra Investment Partners noted that. “It may sound strange, but a ‘buying panic’ in US Treasury bonds is a form of illiquidity. The modern shadow system has in many ways inverted or at least distorted what could fairly be called ‘currency’ or a ‘dollar.’ As I have said on many occasions, repo collateral is in many ways ‘moneylike’ in its be-havior and properties. At times, collateral becomes far dearer than actual currency, or even ledger balances of currency, and thus behaves more ‘moneylike.’ Such derivative function makes straightforward analysis extremely difficult, especially to the outside.” This was a stark illustration of the diminishing liquidity across bond markets. Moving into early 2015, we had the surprising (shocking for many) announcement from the Swiss Na-tional Bank (SNB) on 15 January 2015 when it abandoned its 1.20 peg against the Euro.






Source: ADMISI, Bloomberg The SNB specifically mentioned central bank policy divergence and dollar strength in its statement ex-plaining why it was ending the Euro peg. “Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated con-siderably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar.” In recent days we’ve seen the PBOC devalue the Yuan, which is directly related to dollar pressures (see

below).






Eurodollar liquidity shortage becomes more apparent Dollars, dollars everywhere but… It’s hard not to reflect on the irony that the Fed could create an additional US$4.0 trillion on its balance sheet alone and the world experience a growing shortage of dollar liquidity. At times, it seems that it’s the “flow” that counts far more than the “stock.” Cross-currency basis swaps are used by banks to convert liabilities in one currency into another curren-cy. For example, the more negative the Euro/US dollar 5-year Basis Swap, the stronger the desire on the part of banks to swap Euro liabilities (i.e. Euro deposits which they are absolutely drowning in, thanks to ECB QE) into US dollar liabilities. This is from the New York Fed’s paper “Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs.” “One metric used to measure funding stress in foreign exchange markets is the foreign exchange swap basis. To arrive at this metric, analysts take an implied measure of dollar funding from a foreign exchange swap using the uncovered interest rate parity formula and compare it with Libor. A foreign exchange swap is a contract combining an FX spot and forward transaction and whose price, accord-ing to the uncovered interest rate parity, is derived from the differential between interest rates in the domestic currency and the foreign currency.” The second quarter of 2014 (here we go again) marked the peak in the Euro/US dollar 5-year basis

swap, which has subsequently moved (and remained) well into negative territory as seen in this chart.







The basis swap has correlated closely with the Euro spot rate.

Source: ADMISI, Bloomberg It’s noticeable how sharply the Euro/US dollar swap declined during January to March 2015. By mid-March 2015, the upward pressure on the dollar was such that we can’t help wondering whether this was a factor in the Fed signalling a more dovish approach to tightening at the 18 March 2015 FOMC meeting. With the Yen/US dollar basis swap, there was a very sharp decline towards the end of 2014 - slightly

earlier than we saw in the Euro/US dollar.







The correlation with the Yen has been relatively good since mid-2014, although the basis swap is cur-

rently indicating around 125.

Source: ADMISI, Bloomberg There are private sector dollar swaps and there are official ones coordinated by the Federal Reserve

with other central banks.

The dollar swap facilities set up during the crisis were only meant to be temporary. Notwithstanding

this, they were made permanent standing arrangements on 31 October 2013. The six central banks in-

volved are Federal Reserve, ECB, Bank of Japan, Bank of England, SNB and Bank of Canada.

There are no EM central banks in that list, obviously.

The PBoC, in particular, is a glaring omission for an efficiently functioning financial system based on the dollar/Eurodollar. Before we address the problems faced by the PBOC, it seems that the Fed has extended a new round of

dollar swaps to foreign central banks (most likely to one or more of the six named above) in order to

counteract tightness in Eurodollar liquidity. These dollar swaps are in the form of reverse repos. On its

website, the Fed describes the repo nature of dollar swap lines.

“In general, these swaps involve two transactions. When a foreign central bank draws on its swap line

with the Federal Reserve, the foreign central bank sells a specified amount of its currency to the Fed-

eral Reserve in exchange for dollars at the prevailing market exchange rate…At the same time, the

Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction

that obligates the foreign central bank to buy back its currency on a specified future date at the same

exchange rate. The second transaction unwinds the first.”






These transactions are detailed in the line “Reverse repurchase agreements – Foreign official and inter-

national accounts” on its balance sheet. While the recent spike seems to have gone unnoticed, here is

the chart since 2008.


It’s fairly clear that the spikes have occurred at the time of stress in Eurodollar liquidity. Besides the current episode, there was late 2008 (obviously) and 2010-11 with the Eurozone debt crisis. The next chart shows how the volume of Fed reverse repos with foreign central banks has increased

sharply at times when the cost of Euro/US dollar swaps has spiked (the latter is inverted in the chart).







It’s worth remembering that, in general, dollar swaps undertaken by the Fed only need to “kick in”

when there is insufficient liquidity AND pricing is prohibitive in the FX swap market. The recent surge

makes perfect sense as currency basis swaps for any parties which needed dollars became much more

expensive at the end of 2014/beginning of 2015.

Is the BoE part of this?

We can’t prove it, but it seems that the BoE has been involved in the current expansion of dollar swaps,

helping to backstop banks (probably UK banks) in the Eurodollar market.

On 30 June 2014…and you can’t get more “mid-2014”…the BoE published a statement, “Changes to the

Bank’s weekly reporting regime” in which it explained that it would stop publishing key elements of its

balance sheet (like its SIZE) from the end of September 2014.

You only need to read the first line in the statement…

“A core function of a central bank is to provide liquidity insurance to the financial sector.”

…to know that the reason was to hide any measures to provide liquidity to the banking system. Indeed,

it goes on to acknowledge that.

“Experience suggests that it is more effective for such operations to remain covert at the time, so as not to further undermine confidence in the institution receiving support.” Because the publication of the full balance sheet… “allows observers to identify the presence of liquidity support operations” Exactly. After waffling about the trade-off between the need to be transparent and open and seeking to maintain financial stability (by doing the exact opposite which leads to the under-pricing of risk), the BoE discusses how in the new publication. “the main omissions will be the overall size of the Bank’s balance sheet and ‘other assets’ and ‘other liabilities’.” And in particular. “omit data relating to bilateral operations.” Which obviously includes FX swaps. Regarding the omitted data. “which have the scope to inadvertently reveal the provision of covert liquidity support. Those items will be reported on a quarterly basis but with a five-quarter lag.” On 5 November 2014…interesting because we think Eurodollar liquidity was getting very tight at the

time…the BoE issued a statement on US dollar Repo Operations.






“The Bank of England will, on a regular basis, assess the need for US dollar liquidity-providing opera-tions. It will take into account the fact that standing swap lines have created a framework for the provision of US dollar liquidity to counterparties, if warranted by market conditions. All USD Repo Operations will be unlimited fixed rate SMF (Sterling Monetary Framework) Advances.”

If it looks like a duck (provision of dollar liquidity), walks like a duck…etc. So…we have the Fed increasing dollar swaps and the BoE almost certainly a recipient on a covert basis. Which UK banks have quietly asked for assistance? It might be those with major EM/Asia exposure - Standard Chartered and HSBC would be potential candidates. With the Fed ramping up dollar swaps to DM central banks, almost certainly including the Bank of Eng-land, EM banking systems look especially vulnerable since. They have accounted for the vast proportion of the increase in offshore (Eurodollar) debt since

the last crisis; and They have no dollar swap arrangements with the Federal Reserve. With no dollar swap arrangements with the Fed, they are reliant on using foreign exchange reserves to shore up their banking and shadow banking systems. China is the major player here. The point we are trying to emphasise is that, in our opinion, selling foreign exchange reserves is less about stabilising their currencies and much more about the provision of dollar liquidity. The peak in world foreign exchange reserves just happens to have occurred in mid-2014 (of course)

which obviously corresponded with the low in the dollar before its big move up.







Source: ADMISI, Bloomberg The background to the run on (Euro) dollar liquidity is dollar debt and the substantial proportion of

the global inventory of dollar debt held offshore in Eurodollar accounts.

The build-up of offshore dollar debt since the 2008 crisis has been dramatic. The BIS estimated a level

of US$9.46 trillion by the middle of 2014. This low-balls the actual number since it excludes dollar debt

of banks themselves.

Source: BIS






In effect, the rest of the world is now running a short in the USdollar which is well over US$10 tril-

lion.

When the offshore inventory (US$10.0 trillion +) is so large, there is a transmission of US monetary

policy to the rest of the world as McCauley, McGuire and Sushko of the BIS outlined in “Global dollar

credit: links to US monetary policy and leverage” (January 2015).

“the scale of dollar borrowing outside the US means that US monetary policy is transmitted directly

to the rest of the world in several ways. Changes in the short-term policy rate are promptly reflected

in the cost of…US dollar bank loans…In addition, unconventional monetary policy that reduces re-

turns on Treasury bonds has also led bond investors to step up their extension of dollar credit to

bond issuers outside the US and lowered dollar bond coupons for non-US issuers.”

The bigger the inventory of dollar debt, the more rapid and devastating the transmission mechanism –

which is why we are arguing that the dollar is increasingly acting like a quasi global Fed Funds rate.

In a BIS paper from 2014, “Cross-border banking and global liquidity”, Bruno and Shin concluded that.

“One prediction of our model is that episodes of appreciation of the US dollar are associated with deleveraging of global banks and an overall tightening of global financial conditions.” Exactly.

The overall dollar debt has increased by approximately US$4.0 trillion - about 70% - since the end of

2008. The annual rate of offshore dollar debt growth has generally been in the 8-16% p.a. range since

2010, way ahead of domestic (non-Federal) dollar debt. Here is a BIS chart showing the increase to

June 2014.

Source: BIS






What’s driven such rapid growth?

Empirical studies have shown that offshore dollar debt grows when dollar interest rates (LIBOR) are

below domestic rates and local currencies are appreciating versus the dollar – especially if they are

considered to be a one way bet.

After the crisis, excessively easy credit conditions in the major DM nations, especially the US, were

transmitted across borders into other parts of the world via leveraging of banking and shadow bank-

ing systems.

In their paper,“Transmitting global liquidity to East Asia: policy rates, bond yields, currencies and dol-

lar credit”, Dong He and Robert N. McCauley argue that suppressed interest rates in major developed

economies led to excessive monetary accommodation in other countries, China, Hong Kong and Korea

in this case.

“low interest rates in major currencies make for immediately easier financial conditions where there is a substantial stock of foreign currency credit” But it works both ways, obviously, and there is significant risk from the Fed’s tightening bias.

As the next chart shows, the build-up in this offshore dollar debt since Lehman has been dominated by EM economies. EM accounts for more than US$3.0 trillion excluding an undisclosed share held in “Offshore centres.” Source: BIS

The EM economies and EM asset prices are clearly at risk from a further tightening in Eurodollar

liquidity and the need to counter with the sale of foreign exchange reserves.






Source: ADMISI, Bloomberg Within the inventory of offshore dollar debt, bank lending continues to account for more than 50% of

the total. In a simplistic view of the topology, the global banks tap pools of dollars in major financial

centres, both retail (e.g. deposits) and wholesale (e.g. money market funds and corporate deposits).

The global banks finance cross-border lending of dollars to regional banks which, in turn, lend to local

corporate borrowers.

Since the 2008 crisis, offshore dollar debt in the form of bond issuance has grown much more rapidly

than bank debt.

Source: BIS






This gives portfolio managers a greater role in the transmission of US monetary policy overseas. Hyun Song Shin of Princeton University refers to the acceleration in offshore dollar credit via bond issuance rather than bank credit as the “Second phase of global liquidity” (the first phase being driven primarily by bank lending in the run-up to the last crisis).

This is from McCauley, McGuire and Sushko’s “Global dollar credit: links to US monetary policy and lev-erage” “The compression of bond term premia associated with the Federal Reserve’s bond buying has in-

duced investors to bid for bonds of borrowers outside the US, many rated BBB and thus offering a

welcome spread over low-yielding US Treasury bonds. We also find that inflows into bond mutual

funds offering a spread over US Treasuries played a significant role in spurring offshore dollar bond

issuance. We interpret this as evidence of the portfolio rebalancing channel of the Federal Reserve’s

large-scale asset purchases.”

While many of the EM issuers of dollar debt are either first-time issuers or have low credit ratings,

there is an additional risk. It also concerns us that some of these bond investors may be employing lev-

erage.

The investment attitude of portfolio managers has become dramatically more important for EM cor-

porate funding in recent years – and this represents an additional pro-cyclical source of risk in aggre-

gate.

Last year, Chui, Fender and Sushko of the BIS argued in “Risks related to EME corporate balance

sheets: the role of leverage and currency mismatch” that.

“strong investor interest has underpinned EME corporate bond markets in recent years. If investors

were to suffer a significant loss of appetite, issuing firms might face difficulty in rolling over their out-

standing debts, particularly if shifts in risk appetite coincide with a fall-off in projected earnings…

Many of the recent EME corporate borrowers have gained access to the debt markets, both domes-

tic and international, for the first time. The willingness of investors to let these issuers roll over their

debt in adverse circumstances is thus untested.”

The value of domestic EM bonds has already collapsed – not surprisingly given EM currency weak-

ness…







…and we are keeping a very close eye on EM dollar bond prices which look especially vulnerable right

now.







Hyun Song Shin of Princeton University used the next slide in a presentation on “The Second Phase of

Global Liquidity” which highlights the spiral risk for EM.

Source: Princeton University






China – caught in the squeeze

China is the focal point of this squeeze in Eurodollar liquidity. Its financial system is a prime victim of

“excess elasticity”. This is the build-up of financial imbalances, including over expansion of credit, cur-

rency and maturity mismatches and dangerous expansion of shadow banking conduits.

The direct link between tightening dollar liquidity and monetary conditions in China was clearly illus-

trated with the “taper tantrum” of 22 May 2013, when Bernanke’s taper threat led to a spike in Chi-

na’s 7-day Repo rate...


...and a sharp decline in the Shanghai Composite.







At the centre of this transmission mechanism is a large volume of dollar debt along with:

Currency mismatch - to an undisclosed degree;

Maturity mismatch – a high proportion of loans might be based on short-term wholesale funding;

and

Commodity mismatch – where dollar loans are collaterialised by commodity collateral,

e.g. copper.

By mid-2014, dollar debt to non-financial Chinese borrowers amounted to nearly US$1.1 trillion, hav-

ing increased by about US$900bn since the crisis – see the centre pane in the BIS charts below.

Source: BIS

However, we think Chinese dollar debt exceeds this level significantly as it excludes US$600bn-1.1 tril-

lion (depending on the definition) held in Hong Kong, part of which is attributable to Chinese borrow-

ers (we show the topology of some of these loans below).

In some cases, dollar borrowings might be largely/partially hedged by dollar receivables. While it’s im-

possible to calculate the extent to which intentional currency mismatches were created on corporate

Chinese balance sheets, we think that it is widespread.

Why would so many Chinese borrowers deliberately run a substantial currency mismatch? Because it seemed like a cast-iron way to make money for many years. Besides the arbitrage on interest rates, a currency mismatch can seem very attractive if local borrowers believe that the local currency will continue to strengthen versus the dollar – especially if it is per-ceived as a one-way bet. This was precisely the problem with the Yuan, which was viewed as a one-way bet for many years. This is from the BIS’s He and McCauley paper. “to the extent that domestic currencies are expected to appreciate against major foreign currencies,

currency expectations reinforce interest rate differentials in encouraging firms to borrow in foreign

currency.”






Indeed, for many years China was branded as a currency manipulator by the US for keeping the value

of its currency too strong.


Following the recent devaluation of the Yuan, a Bloomberg story on 27 August 2015 commented.

“The yuan’s devaluation is a wakeup call for Chinese companies that rarely hedge overseas debts…

China’s second biggest steelmaker Baosteel Group Corp, it’s largest auto rental company Car Inc. and

developer Country Garden Holdings Co. said they’re considering hedging after the Aug. 11 devalua-

tion.”

This leads us on to the subject of carry trades.

The magnitude of the dollar/Yuan carry trade is unknown, but market estimates have put it in the US$500bn to US$1.0 trillion, or even higher. This was a comment by the FT. “The perception that the renminbi could only strengthen fueled the so-called carry trade of borrow-

ing US dollars cheaply offshore and then cycling them into China for the higher interest rates and

currency appreciation. That in turn led to wildly inflated trade data as Chinese companies used fake

invoicing as a means to bring money onshore.”

Below is the topology of a Chinese corporate borrowing dollars from Hong Kong, using Yuan deposits

as collateral, with dollars provided either from a parent bank or the wholesale funding market.






Source: BIS

In the scenario above, non-bank corporates effectively became financial intermediaries in stoking the

credit bubble. From Chui et al.

“To the extent that non-financial corporates issue debt but hold the proceeds as liquid claims, they behave as surrogate intermediaries channelling funding from global capital markets into the domes-tic financial system” This should raise an immediate red flag. In this example, the funding is likely to be short-term and raised in wholesale dollar money markets. There is another risk. If local borrowers are holding large deposits in local banks and are merely playing

the carry trade, they could be forced to withdraw these deposits if they are squeezed on the currency.

This could, in turn, put stress on wholesale funding in the local banking system.






It’s possible that the extreme volatility in Overnight HIBOR – the Hong Kong Inter-bank Offered Rate –

is reflecting this stress.

Source: ADMISI, Bloomberg On the subject of Yuan/dollar carry trades, there is the shadow banking conduit where dollar loans are

collateralised by imports of copper (and other commodities) held in bonded warehouses. The close re-

lationship between the rise in the trade-weighted value of the dollar (inverted in the chart below) and

the fall in the copper price since mid-2014 suggests that these trades are being unwound.







It also establishes a link between tighter dollar liquidity and the copper price and is more evidence

that links between US monetary policy, dollar liquidity and the Chinese economy are broad/

complex.

Besides the plain vanilla balance sheet dollar short and the commodity-backed “shadow” dollar short,

Jeff Schneider of Alhambra Partners writing (prophetically) in March 2014 makes the case for a trans-

actional short related to.

“Chinese companies that export to the US (e.g. Foxconn) are not the same companies that import

resources for all that manufacturing and assembling. The exporters gain a surplus of dollars, but

have to turn them over (through Chinese banks) in large part to the PBOC (China’s central bank) to

maintain that peg. Importers in turn have to obtain dollars to purchase materials on the global mar-

kets because there is, as yet, no depth in yuan trading outside narrow, bespoke bilateral arrange-

ments”

Schneider continued.

“That means that the Chinese corporate sector is ‘short’ dollars to conduct global trade. Exporters

had a surplus but gave it up to the PBOC, and importers have to borrow dollars from either foreign

banks onshore or native Chinese banks that themselves have to borrow dollars. Somewhere in that

dollar chain lays Eurodollar market rollovers. That links US dollar ‘tightening’ to Chinese liquidity.”

Once again, this emphasises a key issue which is the need to fund and roll over China’s dollar short in

wholesale funding markets.

As the shortage of Eurodollar liquidity has intensified, this has become more problematic.

This issue is being hindered by capital outflows from China which began last year. Capital flows as

measured by “China Balance of FX Settled and Sold by Banks”, turned negative in Q3 of 2014.







We showed above how world forex reserves peaked in mid-2014, coinciding with the start of the dol-

lar’s upward move and breakout of the 30-year wedge. A similar thing happened with China – just

slightly earlier in 2014.

Source: ADMISI, Bloomberg That fits, once again, with the initial impact of the Eurodollar shortage impacting China in the early part of 2014. Source: ADMISI, Bloomberg






We believe that the primary reason for China’s sale of forex reserves and US Treasuries sales (reportedly US$100bn+) has not been to support the Yuan, but to provide wholesale Eurodollars to its banking system. When the Fed raises rates, it’s fair to say that the rest of the world faces a more serious risk than ever before, especially China. Here is Borio and McCauley from the BIS in “Transmitting global liquidity to East Asia…” (with our emphasis). “The transmission of global liquidity to Asian economies needs to be understood and taken into ac-count by policy-makers in the region and in the key currency countries. It is worth recalling that the deflationary shock from the currency depreciations during the Asian financial crisis in 1997–98 inter-rupted the tightening phase of the Federal Reserve, with implications for asset markets. The already difficult exit from very accommodative policy over the next several years would only be more chal-lenging in the event of financial instability in East Asia…In other words, if no account is taken of spill-overs, there is a risk of instability with blow-back effects to major economies.” An exit from ZIRP is complicated by the fundamental change to the mechanics of implementing a rate

increase now that the formerly used Fed Funds mechanism is no longer effective. Furthermore, the

proposed new mechanism is much more deeply integrated into the shadow banking system.






Fed policy – now complicated by shadow banking The implementation of Fed policy going forward is going to be far more complex than it has been his-torically. Not only has the traditional Fed Funds mechanism been rendered irrelevant by QE but the knock-on effect of Fed policy on the rest of the world is so much greater and stresses in the “plumbing” could be exacerbated. This is a risky environment for the Federal Reserve to propose to raising rates, albeit from a very low level. In addition, further complicating matters (potentially), US banks currently play a minor role in dollar credit markets outside the US and a reduced role in domestic wholesale money markets vis-à-vis US branches of foreign banks. Changing Fed interest rate policy going forward is no longer just a simple case of the Federal Reserve

establishing a higher interest rate in the Fed Funds market. The Fed’s QE programmes broke the Fed-

eral Reserve’s traditional monetary transmission mechanism by all but killing off the Fed Funds

(bank reserves) market. The Fed Funds market has dwindled to about US$50bn, having been US$250-

300bn in the past.

In those days, the Fed ensured that there was tension in the market for banks reserves, then it instigat-

ed QE and the banking system became awash with (currently) just over 2.5 trillion of excess reserves.






Source: ADMISI, Bloomberg As Simon Potter, head of the FRBNY’s markets desk, noted in a speech on 15 April 2015, the volume of excess reserves is at “a level at which the Open Markets Trading Desk (the Desk) will be unable to move the effective fed-eral funds rate up or down with small variations in the supply of reserves, as it did before the finan-cial crisis.” Weirdly, when the Fed adjusts rates in future it will (still) target an interest rate (Fed Funds) for a market which is far smaller and far less relevant than ever before. This is supposed to help people who don’t understand what’s going on or how money markets have changed. The flexibility to move Fed Funds to a desired rate in the new environment was the cue to devise a new transmission system, which is basically an interest rate corridor. The ceiling of the corridor, which is expected to be 25 bp wide, will be IOER which will be set according to the top of the target range for the Federal Funds rate. However IOER is only available to banks. The FRBNY’s William Dudley commented in a speech “The US Economic and Monetary Policy Outlook” on 5 June 2015. “Most importantly, we have demonstrated that the interest rate paid on banks’ reserve balances (IOER)—which is our primary tool to raise the federal funds rate target—and daily overnight reverse repo (ON RRP) operations—which is a supplementary tool to help put a floor under money market rates” In our opinion, IOER is not the “primary tool” – at least not until bank reserves become somewhat

“scarce”, which is a distant prospect.






Instead the primary tool will be the Fed’s ON RRP, which was first introduced on a pilot basis in Decem-ber 2013. Currently it pays 5 basis points and is limited to US$30bn per counterparty and a total vol-ume of US$300bn (and averaging US$120bn during the last 12 months). The aim of the ON RRP is to set the floor of the rate corridor and to lead other rates in US money mar-kets. The potential difficulty arises with a Fed “liftoff” when, in order to be effective, the Fed has to in-clude a sufficiently broad set of non-bank financial institutions in the money markets. Eligible ON RRP counterparties include banks, GSEs, Federal Home Loan Banks and money market funds (MMFs) and, consequently, a potential volume of funds which amounts to many US$ trillions. It’s also uncer-tain how much support is currently being provided by having interest rates so close to the zero bound at present, something which would be lost on “liftoff”. The Fed has (at least) three problems.

How big does any cap on the ON RRP need to be or should it be unlimited (full allotment)?

If it’s not big enough when the Fed raises rates by (say) 25bp, many money market and shadow banking rates might fail to fully follow the Fed’s lead, e.g. only rising by 5-10bp.

Will the Fed’s ON RRP facility be so attractive that it “crowds out” other borrowers in the money

and shadow banking markets? Not surprisingly, the Fed has been thinking about these issues as has been clear from FOMC minutes. This was from the 17-18 March 2015 meeting, for example. “A staff briefing provided background on options for setting the aggregate capacity of the ON RRP facility in the early stages of the normalization process. Two options were discussed: initially setting a temporarily elevated aggregate cap or suspending the aggregate cap for a time.” This is an extremely difficult judgement for the Fed…one which is impossible to know the answer ahead of time…and which could be impacted by changing financial conditions. A key question is… Why wouldn’t the money market fund (MMF) industry and other non-bank financial institutions in-vest a substantial amount (or most) of their funds with the Fed’s RRP? The counterparty risk with the Fed is theoretically zero and most MMFs are not in the business of

“reaching for yield” even if alternative investments offer marginally higher yields. The Fed doesn’t

want to take the majority of the money markets on its balance sheet.






So, while paranoid about being “big enough” the Fed is equally concerned about a full allotment approach, which could also have undesirable effects. The Fed, via Potter in his 15 April 2015 speech, is talking confidently - full allotment is not necessary in his view. “Through testing, we've learned that the fixed-rate and full-allotment features are not necessary for securing interest rate control. Moreover, by supplying a perfectly elastic quantity of a risk-free asset at a fixed-rate, a fixed-rate, full-allotment ON RRP facility might have undesirable effects on financial stability” Maybe…but it might have to be very big still. For example, the total value of MMFs is still over US$2.5 trillion, even if it’s well down on 2008 levels.


Under the current programme, the Fed executes ON RRPs with MMFs accounting for about 70% of the total. In a liftoff scenario, what volume of MMF assets might the ON RRP attract…US$0.5 trillion, US$1.0 trillion, US$1.5 trillion? Who knows! So the Fed probably has to go “big” at first…but this could have unintended consequences. What if the Fed “crowds” out other participants in the money markets?

Who will buy many of the short-term credit instruments that need funding? For example, Commercial Paper issued by banks and large corporate borrowers, bank CDs and short-term Agency debt.






The Commercial Paper market, for example, has also shrunk in size since the 2007-08 crisis, but is still

in excess of US$1.0 trillion.

Source: ADMISI, Bloomberg MMFs account for about 50% of lending to CP borrowers, making this sector particularly vulnerable if MMFs substantially increase their Fed RRP activity. A funding crisis in the CP market is possible and the average maturity is only several days. Ironically, the last time there was a funding crisis in CP (post-Lehman), the Fed needed to create a facil-ity using its balance sheet to lend to banks so that they could purchase (AB)CP from MMFs. While this was partly to allow MMFs to meet redemption requests, it also allowed CP issuers to roll maturing pa-per. It’s also unclear to what extent money market rates are currently being supported from being so close to zero. As Potter highlights. “Importantly, we will likely not know the level of support that proximity to the zero lower bound has provided to money market rates until we start to move away from it. Demand for ON RRPs following liftoff could remain relatively steady. But it could conceivably be much greater than what we have seen at higher levels of interest rates or as regulatory and structural changes in money markets boost demand for safe assets” Another problem for the Fed is that the ON RRP could become “super attractive” to participants in wholesale money markets during periods of financial turbulence. Even Potter acknowledges this.






“In periods of financial stress, the availability of a fixed-rate, full-allotment facility could enable a rapid or unexpected expansion that exacerbates disruptive flight-to-quality flows by facilitating a run away from funding financial institutions and nonfinancial corporations. This dynamic could under-mine financial stability.” Exactly. And if it’s not full allotment at the time (or the cap is not set at a very high level), rates will probably crash to zero and the Fed would lose control. Liftoff is going to be a challenge for the Fed and it’s an uncertainty which is not well understood by many investors. The Fed has emphasized that the ON RRP is only meant to be temporary but it looks like it might need to be in place for a prolonged period of time in our opinion. Furthermore… We already have a dollar liquidity issue which seems to be focused in offshore (Euro) dollar markets. Tightening monetary policy via the ON RRP risks catalyzing destabilizing capital flows in a financial-ised global economy.






Financialism and defensive stance on Equities There is no agreed definition of “financialism”, but the general principle is the vastly increased role of finance during the last 30-40 years at the expense of the real economy. This was Lawrence E. Mitchell writing about the US economy in his book “The Embedded Firm.” Unfortunately we have more sympathy with his view than we’d like. “It has created a new economic system that appears to be capitalist but no longer performs the func-tions of capitalism. Capitalism is a system in which wealth is created and sustained by the production of goods and services determined through market supply and demand. A variety of related struc-tures support capitalism, including the institutions of finance, which provide the funds necessary for the production and trade of goods and services. While capitalism still characterizes a portion of the American economy, it has become subordinated to a new economic order…This new economic sys-tem is Financialism.” While we have focused on excessive credit creation and the volume of global speculative capital, finan-cialism comes in many guises. The power of financial markets and speculative capital within;

Reliance on central banks to rescue TBTF financial institutions and support financial markets at critical moments;

Unhealthy influence of major investment and commercial banks;

The stock of globally traded financial assets has increased from US$7 trillion in 1980 to some-

thing approaching US$200 trillion.

Securitisation of just about any financial obligation;

Financially-driven transactions, e.g. share buybacks;

High frequency and algorithmic trading methods;

Financial performance targeting;

Personnel involved in financial services (including compliance); and

Innovation in financial instruments, especially in derivatives (“claims on claims on claims” which

become ever more removed from what most people would view as “reality”).

Central banks are important facilitators of financialism via ZIRP policies, credit creation and interven-

tion/subversion of free markets.






Surges/reversals in speculative capital are never taken into account by static economic models. Under the “right” conditions, speculative capital flows can overwhelm almost anything in their path. As we undertook our research, we found that the BIS had grasped the idea of financialism, even if it

didn’t use the term. In August 2014, Claudio Borio of the BIS argued that.

“the Achilles heel of the international monetary and financial system is that it amplifies the ‘excess financial elasticity’ of domestic policy regimes, i.e. it exacerbates their inability to prevent the build-up of financial imbalances, or outsize financial cycles, that lead to serious financial crises and macro-economic dislocations.” The chart below neatly illustrates the general message regarding the rising tide of financialism.

Source: BIS In a 2014 paper by Claudio Borio (again) and Hyun Song Shin, “The International Monetary and Finan-cial System: A Capital Account Historical Perspective”, they argued. “in a highly globalised economy financial markets hold sway” We couldn’t agree more.






With regard to the equity market, we had searched (as per previous reports) for technical indicators

which gave well-timed sell signals on the S&P 500 at the last two bull market peaks in March 2000

and October 2007.

In March 2015, we highlighted what we found to have been the best one, which we referred to as the “Adjusted MACD Indicator”. MACD stands for Moving Average Convergence/Divergence. It consists of three time series. MACD series; the “signal” or “average” series; and

the divergence between the two. From Wikipedia. “The MACD series is the difference between a ‘fast’ (short period) exponential moving average (EMA) and a ‘slow’ (longer period) EMA of the price series. The average series is an EMA of the MACD series itself. The MACD indicator thus depends on three time parameters, namely the time constants of the three EMAs. The notation ‘MACD(a,b,c)’ usually denotes the indicator where the MACD series is the difference of EMAs with characteristic times a and b, and the aver-age series is an EMA of the MACD series with characteristic time c. These parameters are usually measured in days. The most commonly used values are 12, 26, and 9 days, that is, MACD(12,26,9).” Please also note that an EMA uses exponentially decreasing weights to older data points in a time series.

While the MACD is normally calculated on EMAs of 12, 26 and 9 days, we noted that the best indi-cation for predicting the last two peaks in the equity market was 25, 26 and 9 days. Based on fur-ther work, we have established that the best combination is based on EMAs of 25, 26 and 6 days. This gave sell signals on the S&P 500 in February 2000, i.e. one month before the 2000 peak, and December 2007, that is two months after the 2007 peak. At end-June 2015, we saw the first month-end crossover from positive to negative in the Adjusted MACD since December 2007.






Below is the current monthly adjusted MACD chart for the S&P 500 since 1998. You can see in the

chart that the white line in the lower pane has crossed below the red line. This results in a negative

value for the relevant green bar which measures the difference between the white and red lines.

Source: Bloomberg

The S&P 500 made a closing high in the current bull market on 21 May 2015 at 2,130.8 and almost reached this level again, when it closed at 2128.3. Our cautious stance towards equities highlighted in the 6 July 2015 report “S&P500: technical indicator which called the 2000 & 2007 peaks gives first sell signal for current bull market in Equities” remains in place as does our preference for defensive posi-tioning in sectors and stocks.






It is beyond the scope of the current report, but sectors which could be at risk include (rather obvious-

ly) Banks – where any escalation of problems in the “plumbing” are not priced in.

Here is the US Banks sector (BKX) relative to the S&P 500 since 2012.


And the Euro Stoxx Banks sector relative to the Euro Stoxx 50 index.







We would also highlight.

Capital Goods – structural weakness in global capital investment cycle and risks to long-term in-

vestment horizons;

Autos – rapid slowdown in China and unsustainable level of US production driven by cheap (sub-

prime) financing and inventory build.






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