The Battle between Liquidity and Instability
“A funeral eulogy is a belated plea for the defense delivered after the evidence is all in.”
- Irvin S. Cobb
US exports slouched in October. Actually, they tanked so badly the trade deficit widened despite a drop in imports.
Luckily, the Federal Reserve meets today and will announce monetary policy changes and their economic outlook tomorrow.
In light of the dismal export number, the Fed may or may not be thinking “Damn that US dollar.”
Surviving the central bank
After propping up asset markets, the Fed’s unstated goal seems to be devaluing the US dollar to support America’s terms of trade and help the economy grow out of the depression in which it is currently mired. On top of never-ending bond purchases and quantitative easing, the Fed’s extended period of low rates now reaches to the start of 2015.
Since the second quarter of 2011 the US dollar rallied as much as 15%. Currently it’s up 10% from the low last year. This certainly must frustrate Ben Bernanke and Co. Though, admittedly, much of the dollar’s appreciation has stemmed from Eurozone-specific crises that weighed down on the euro.
In the time frame below, it looks as though a head-and-shoulders pattern is looming. If the dollar breaks below the 78-range, the Fed may be given reason to celebrate:
How is a currency to survive a central bank policy like this?
Well, the dollar could hold ground because the rest of the world doesn’t like the Fed’s approach so much. So, to counteract it, they must flirt with similar policies so that their currencies remain competitive and their economies remain stable.
Brazil continues to make a fuss of the loose policies of the developed world. They’ve tinkered with capital controls to keep their economy from blowing up. Thailand has too. But perhaps this trend of capital controls is still in its infancy.
What’s not in its infancy is loose monetary policy among emerging markets.
For starters, Asian economies have been forced to compete with an undervalued Chinese renminbi. And increasingly, developed market outflows stemming from Fed, ECB and BOJ policies are creating stress on developing economies. Further, the low-rate policies of these core economies translates to borrowers in emerging economies even without official rates on emerging market bonds changing.
I took the following chart from a Bank for International Settlements (BIS) paper:
Where global policy finds itself, a return to normal is nearly impossible. And that’s largely because …
The Fed won’t quit
The Fed is widely expected to announce new bond buying tomorrow.
They are determined to keep interest rates low? It begs the question: Why, since levels below the natural rate of interest suppress the market process, obstruct the natural flow of capital, mutate the financial system and lay unavoidable economic land mines?
Because the US financial position is so crummy.
Without low borrowing costs (and lower rates at which the US can service its debt), the US budget could never be considered remotely “sustainable.”
The Federal Reserve has a huge task on its hands. If it means avoiding any potential increase in interest rates, they won’t be giving up anytime soon … no matter how much the rest of the world may want them too.
Liquidity vs. Instability
It all depends on the consensus right now.
The liquidity provided by core central banks is serving to drive down the cost of debt and drive up asset prices. This is the grand theme moving the markets. Perhaps investors believe a truly sustainable recovery can emerge from the oceans of pent-up central bank money.
The risk is if the consensus changes its mind.
While some have long-held beliefs that current policy is not conducive to sustainable growth, other views are emerging to suggest significant global instability is lurking in the shadows of loose monetary policy.
Instability may very well be imminent.
More than two years ago we penned a special report called Currency Wars. In it, we showed the inverse correlation between emerging market investments (e.g. stocks and currencies) and the US dollar. That is: the weak-dollar policy in the US drove capital into emerging markets and caused investors to bid up those riskier assets.
While the Fed’s weak-dollar policy may not have changed, it is certainly long in the tooth. As such, a weak dollar may not be the ultimate outcome going forward. If global instability is imminent, and the consensus recognizes it, you can bet it won’t lead to investors bidding up the riskier assets of emerging markets again.