KING DOLLAR AND THE PERIPHERIES / PRUDENTBEAR.COM

King Dollar and the Peripheries

by Doug Noland

September 12, 2014 

Things are turning interesting again. An interesting week saw the Brazilian real get hammered for 4.2%, as Brazil’s stocks sank 6.2%. Venezuela Credit default swap (CDS) prices surged 158 bps to 1,464 bps (lagging Argentina at 1,840!). Turkish stocks were hit for 5.3%, in what Bloomberg called the emerging-market stocks’ “steepest decline in 15 months.” Commodities currencies were also pummeled. The Australian dollar dropped 3.6%, the South African rand 3.0%, the New Zealand dollar 2.1% and the Canadian dollar 1.9%. The Goldman Sachs Commodities Index was hit for 2.4%, trading this week to the lowest level since the tumultuous summer of 2012. Brent crude fell to a two-year low, wheat to a 50-week low and gold to an eight-month low. Spanish yields jumped 30bps, with Italian yields up 20 bps and France’s 17 bps. U.S. junk bond CDS jumped 21 bps this week. In the face of unsettled global risk markets, 10-year Treasury yields jumped 15 bps this week.span style="background-


Market and macro analysis remains extraordinarily challenging. The U.S. economy shows momentum and financial conditions remain ultra-loose. Wall Street strategists are universally bullish. A recent survey (Investors Intelligence) had the smallest reading of bears since 1987. Sentiment is buoyed by the view that it will be years before the Fed raises rates to the point where they would weigh on risk asset prices.


It’s no surprise that I see the greatest financial Bubble in history. I believe asset market inflation and Bubbles have been fueled by speculative leverage exceeding pre-2008 crisis levels. I see global financial and economic imbalances that have been exacerbated by six years of the most extreme monetary policy measures. By now, this type of analysis has been completely discredited. Few will care that I discern acute vulnerabilities.

There was important confirmation of my analytical thesis back in the spring of 2013. The so-called “taper tantrum” saw the emerging markets (EM) under heavy selling pressure. Global (highly correlated) risk asset prices began to falter. Importantly, in the face of heightened risk aversion, Treasury yields moved higher. This was problematic for many popular leveraged strategies that incorporate “safe haven” Treasuries as a hedge against other risk asset classes (equities, corporate debt, EM and commodities). I still believe overheated global markets were on the brink of a meaningful bout of “risk off” de-risking/de-leveraging. But immediate support from the likes of Bernanke (“The Fed will push back…”) and Dudley ensured that fledgling “risk off” was transformed into an only more emboldened “risk on.” Today, market prices are higher and the latent risks only greater.

Assuming QE would wind down this year, I’ve been on guard for a reemergence of the “May/June (2013) Dynamic.” Back in late-March I titled a CBB “The April, May, June Dynamic?” Spring – and most of summer – came and went. In spite of an alarming deterioration in the global backdrop, a most determined “risk on” held sway.

This week, however, saw the emergence of a backdrop increasingly conducive to “risk off.” Currency market instability is turning into a critical issue for global risk markets. The dollar index traded this week near the highest level since 2010. Importantly, EM currencies, for the most part having held their own, have now begun to show fragility. So far in September, the Brazilian real is down 4.4%, the Colombian peso 3.8%, the South African rand 3.2%, the Turkish lira 2.7% and South Korean won 2.1%. Arguably, “King dollar” is becoming a growing risk to economies and financial systems around the world.

Federal Reserve post-2008 crisis reflationary measures were a catalyst for a momentous global “reflation trade.” Fed zero rate policy and massive debt monetization both pressured the dollar and flooded the world with liquidity. The EM complex was the greatest beneficiary of this liquidity onslaught. On the back of unfettered domestic Credit expansions and torrential global financial flows, EM economies were well-placed to assume the role of global growth locomotives. Regrettably, an unusually protracted period of Credit, speculative excess and malinvestment has left the EM complex vulnerable to a reversal of “hot money” flows.

EM market and economic Bubbles were at heightened vulnerability back during the unfolding summer of 2012 crisis. Unprecedented measures (including open-ended QE) prolonged Bubble excess. One would have reasonably expected $1.5 TN of new Federal Reserve “money” to weigh on the dollar and stoke further commodity price inflation – in the process benefiting developing economies. This liquidity instead flowed freely to inflating securities markets, spurring price gains and issuance, including record prices and debt sales throughout U.S. equities and corporate Credit. Too much global liquidity chasing securities markets returns has provided powerful dollar support (reminiscent of the late-nineties “King Dollar” period).

How might the unintended consequences of QE and rate manipulations come back to jeopardize market stability? While not always readily apparent, ultra-loose finance often exerts its greatest impact upon the “marginal” players. Globally, “developing” nation governments, corporations and financial institutions over recent years have enjoyed the most favorable access to finance imaginable. The perception of a reflationary global backdrop ensured too many marginal EM borrowers accumulated too much debt of which too much was denominated in U.S. dollars. In the Eurozone, the periphery countries have been the overwhelming winners amid “do whatever it takes” coupled with global liquidity overabundance. Here at home, junk bonds, leveraged loans and all varieties of “subprime” finance have flourished amidst the liquidity bonanza.

Importantly, the windfall at the Periphery has run unabated despite the impending conclusion of Fed QE. For the most part, there has been scant indication of waning liquidity overabundance. The bulls point to a dovish Yellen Fed, hence prospects for a supportive rate backdrop for some time to come. Furthermore, they see ongoing BOJ QE and a Draghi ECB willing to grab the QE baton from the Federal Reserve. Negative global fundamentals have nourished the bullish imagination.

What could go wrong? Well, all analytical eyes should now be focused “at the margin.” It is the nature of speculative Bubbles to create their own self-reinforcing liquidity. It’s the inherent nature of Bubbles to “overshoot” – the nature of speculative melt-ups to overwhelm markets right in the face of deteriorating fundamentals. I still see the end of QE as a pivotal development, although exuberance and speculative leveraging have continued to fuel the perception of limitless cheap liquidity. Stated differently, I believe the markets are at this point acutely vulnerable to any shift from risk embracement to risk aversion. The policy backdrop has ensured that markets remain excessively bullish in the face of bearish prospects. The various “Peripheries” would appear acutely vulnerable to a destabilizing reversal in market sentiment and flows.

The question is always, “Doug, what’s the catalyst?” How about increasingly unstable global currency markets? How about the trials and tribulations of King Dollar? How about the potential for a serious bout of “risk off” speculative de-deleveraging unfolding without the benefit of Bernanke’s reliable liquidity backstop?

I do suspect there is unprecedented global leverage in various currency “carry trades” – perhaps the key unappreciated source of speculative leverage for this global Bubble cycle. I have posited that the “yen carry” (short/sell low-yielding yen instruments to fund higher-yielding securities around the world) could be history’s greatest speculative wager. Recent yen weakness has supported this huge winning trade. At the same time, recent currency market volatility and general instability have meaningfully elevated the risk of leveraged “carry trades”/speculations. Indeed, the currency markets have become a veritable minefield of risk.

The U.S. economy today commands a decent head of steam, bolstered by record securities prices, ultra-loose finance and record corporate debt issuance. This provides ammunition to the Fed hawks, boosting policy and market uncertainty. Despite unprecedented QE and a devalued yen, the Japanese economy has performed dismally. Do Japanese policymakers double-down or begin to recognize the risks associated with faltering yen confidence? Throughout Europe, economies have performed poorly. Mario Draghi talks a tough game, though there is in reality considerable uncertainty as to the ECB’s ability to implement quantitative easing. There is great uncertainty and potential for the Europe to disappoint on multiple fronts. And with their currency basically tied to ours, what impact does King dollar have on a weakening China beset by overcapacity and a plethora of uneconomic industries?

The U.S. dollar has been winning on multiple fronts – European and Japanese stagnation and prospects for more central bank monetization. An increasingly alarming geopolitical backdrop has boosted the perception of dollar as safe haven. The dollar was supported further from British pound weakness as a nervous marketplace cut exposure heading into what appears will be a close referendum on Scottish independence. And each bump in the dollar feeds the prospect for a big dollar market overshoot, in the process increasing probabilities for a destabilizing unwind of various trades around the globe and across asset classes. As commodities prices have wilted, pressure on the so-called “commodities currencies” has further inflamed King Dollar. And as U.S. securities outperform globally, more “hot money” flows to the U.S. at the expense of The Peripheries. Unprecedented abundance has provided sufficient liquidity for all. But for how long?

September 12 – Financial Times (Andres Schipani in Bogotá and John Paul Rathbone): “Venezuela is struggling to meet its international bond payments, raising the spectre of an Argentine-style default despite the Opec country’s massive oil reserves. Yields on Venezuelan bonds, the third-largest constituent of JPMorgan’s global emerging bond index, have risen since Caracas put Citgo, the country’s US refining operation, up for sale and scrambled to reassure investors it can refinance $7bn coming due this year on its more than $80bn of sovereign debt… A Venezuelan default could be widely felt. The country accounts for 7% of emerging market benchmarks, meaning a default could force redemptions of other investments by passive index-tracking funds… Until recently, bond investors drew comfort from Venezuela’s $85bn annual oil exports. But confidence was shaken this week as yields on short-dated bonds issued by PDVSA, the state owned oil company, shot above 25%.”

Venezuela CDS surged 163 bps this week to 1,443. King dollar weighs on Venezuela on multiple fronts. The strong dollar places downward pressure on crude prices, Venezuela’s big export. Weak commodities prices feed market nervousness and a tightening of finance for commodity-based economies and perhaps even EM generally. And a tightening of financial conditions for EM would weigh on confidence in the global economy, which would further weigh on commodity prices…

It is worth noting that the Brazilian real dropped 1.8% Friday and 4.2% for the week. Brazil’s Bovespa equities index sank 2.4% Friday and 6.2% for the week. With a weak economy and looming elections, Brazil is vulnerable. And with Brazil distinguished as a “core” Periphery market, a lot may be riding on market sentiment. To this point, exuberant global markets have been willing to overlook a litany of troubling fundamental developments – including festering social tension.

And on the topic of social instability, it is worth noting that estimates placed the number of Catalonian pro-independence protestors at 1.8 million in Barcelona on Thursday. Spain’s Prime Minister Rajoy has called the referendum for an independent Catalonia unconstitutional – and has stated it won’t be tolerated. Energized by next week’s Scottish referendum, the Catalan independence movement appears unwilling to take Madrid’s no for an answer. Spain’s, at the “core” of the Eurozone Periphery, saw its bonds get walloped this week.

When I look at the likes of the UK/Scotland, Brazil and Spain, I can’t help but feel that these troubling backdrops are anything but isolated and anything but unrelated to all the central bank “money” that’s been slushing about. This QE onslaught continues to feed the most inequitable distribution of wealth in history. The post-2012 central bank-induced melt-up in global securities prices has too conspicuously enriched the wealthy with few trickledown benefits for the frustrated majority. There is also little doubt in my mind that Western dominance of global finance is at the heart of the alarming deterioration in the geopolitical backdrop, certainly including an aggressive Russia and increasingly assertive China.

It’s fair to question how my global macro analysis could potentially impact the U.S. markets and economy. The abbreviated response focuses on the global nature of today’s Bubble. As we saw in the spring of 2013, worries of potential EM outflows can translate into fears that EM central banks might be forced to sell some of their horde of Treasuries. Moreover, currency market instability and losses in global markets lead to general risk aversion that can feed into U.S. markets through various channels.

Back in June 2013, a bout of global risk aversion corresponded to a reversal of flows from various ETF projects. This impact was felt most acutely in some of the products that traffic in less than liquid underlying securities, including municipal debt and small cap stocks.

It is certainly notable that the marketplace seemed to be showing some liquidity nervousness late this week. Friday saw the small cap Russell 2000 drop 1.0%, while the REITs were smacked for more than 2%. The week also saw outflows from both junk bond and bank loan funds. Especially with the U.S. economy bustling and the M&A market on absolute fire, the pipeline of corporate debt to sell is plumb full. From my perspective, it would appear an especially inopportune time for a surprising bout of “risk off.”

Yet all that’s required for a problematic “risk off” is for the leveraged players to turn more cautious, spurring a reversal of flows out of U.S. equity and corporate Credit ETFs. And with bullish sentiment and global uncertainties both at extremes, one really should expect the unexpected. That Treasuries and global bond markets so overshot on the upside before abruptly reversing course this week only adds to general market instability. That the global leveraged speculating community is struggling with performance also only adds to market vulnerability.