by Tyler Durden
September 06, 2015
Why did we focus so
much attention yesterday on a post
the IMF confirmed what we had said
since last October, namely that the BOJ's days of ravenous debt
monetization are coming to a tapering end as soon as 2017 (as
willing sellers simply run out of product)?
because in the global fiat regime,
asset prices are nothing more than an indication of central
Or, as Deutsche Bank puts it:
"Ultimately in a fiat money
system asset prices reflect "outside" i.e. central bank
money and the extent to which it multiplied through the
The problem is that the
BOJ and the
ECB are the only two remaining
central banks in a world in which Reverse
QE aka "Quantitative Tightening" in
China, and the FED's tightening in the form of an upcoming rate hike
the FED loses all credibility and
reverts its pro-rate hike bias), are now actively involved in
reducing global liquidity.
It is only a matter of time before the
market starts pricing in that the Bank of Japan's open-ended QE has
begun its tapering (followed by a QE-ending) countdown, which will
lead to devastating risk-asset consequences.
The ECB, which is also greatly supply
constrained as Ewald Nowotny
admitted yesterday, will follow
But while we expanded on the Japanese
problem to come
in detail yesterday, here are some
key observations on what is going on in both the U.S. and China
as of this moment -
the two places which all now admit are the culprit for the recent
equity selloff, and which the market has finally realized are
actively soaking up global liquidity.
Here the problem, as we initially
last November in "How
The Petrodollar Quietly Died, And Nobody Noticed", is
that as a result of the soaring U.S. dollar and collapse in oil
prices, Petrodollar recycling has crashed, leading to an outright
liquidation of FX reserves, read U.S. Treasury's by emerging market
This was reinforced on August 11th
when China joined the global liquidation push as a result of its
devaluation announcement, a topic which we also covered far ahead of
everyone else with our May report "Revealing
The Identity Of The Mystery 'Belgian' Buyer Of U.S. Treasurys",
exposing Chinese dumping of U.S. Treasury's via Belgium.
We also hope to have made it quite clear
that China's reserve liquidation and that of
the EM petro-exporters is really
two sides of the same coin:
in a world in which the USD is
soaring as a result of FED tightening concerns, other central
banks have no choice but to liquidate FX reserve assets: this
includes both EMs, and most recently, China.
Needless to say, these key trends
covered here over the past year have finally become the biggest
mainstream topic, and have led to the biggest equity drop in years,
including the first correction in the S&P since 2011.
Elsewhere, the risk devastation is much
more profound, with emerging market equity markets and currencies
crashing around the globe at a pace reminiscent of the Asian 1998
crisis, while in China both the housing and credit, not to mention
the stock market, bubble have all long burst.
Before we continue, we present a brief
detour from Deutsche Bank's Dominic Konstam on precisely how
it is that in the current fiat system, global central bank liquidity
is fungible and until a few months ago, had led to record equity
asset prices in most places around the globe.
Let's start from some basics.
Global liquidity can be thought
of as the sum of all central banks' balance sheets (liabilities
side) expressed in dollar terms.
We then have the case of completely
flexible exchange rates versus one of fixed exchange rates. In
the event that one central bank, say the FED, is expanding its
balance sheet, they will add to global liquidity directly.
If exchange rates are flexible this
will also mean the dollar tends to weaken so that the value of
other central banks' liabilities in the global system goes up in
Dollar weakness thus might
contribute to a higher dollar price for dollar denominated
global commodities, as an example.
If exchange rates are pegged then to achieve that peg other
central banks will need to expand their own balance sheets and
take on dollar FX reserves on the asset side.
Global liquidity is therefore
increased initially by the FED but, secondly, by further
liability expansion, by the other central banks.
Depending on the sensitivity of
exchange rates to relative balance sheet adjustments, it is not
an a priori case that the same balance sheet expansion by the
FED leads to greater or less global liquidity expansion under
either exchange rate regime.
Hence the mere existence of a
massive build up in FX reserves shouldn't be viewed as a massive
expansion of global liquidity per se - although as we shall show
later, the empirical observation is that this is a more powerful
force for the "impact" of changes in global liquidity on
That, in broad strokes, explains how and
why the FED's easing, or tightening, terms have such profound
implications not only on every asset class, and currency pair, but
on global economic output.
Liquidity in the broadest sense tends to support
growth momentum, particularly when it is in excess of current
Positive changes in liquidity should
therefore be equity bullish and bond price negative. Central
bank liquidity is a large part of broad liquidity and, subject
to bank multipliers, the same holds true.
Both FED tightening and China's FX
adjustment imply a tightening of liquidity conditions that, all
else equal, implies a loss in output momentum.
But while the impact on global economic
growth is tangible, there is also a substantial delay before its
full impact is observed.
When it comes to asset prices, however,
the market is far faster at discounting the disappearance of the
Ultimately in a fiat money system
asset prices reflect "outside" i.e. central bank money and the
extent to which it multiplied through the banking system. The
loss of reserves represents not just a direct loss of outside
money but also a reduction in the multiplier.
There should be no expectation that
the multiplier is quickly restored through offsetting central
Here Deutsche Bank suggests your panic,
because according to its estimates, while the U.S. equity market may
have corrected, it has a long ways to go just to catch up to the
dramatic slowdown in global plus FED reserves (that does not even
take in account the reality that soon both the BOJ and the ECB will
be forced by the market to taper and slow down their own liquidity
Let's start with risk assets,
proxied by global equity prices.
It would appear at first glance
that the correlation is negative in that when central bank
liquidity is expanding, equities are falling and vice versa. Of
course this likely suggests a policy response in that central
banks are typically "late" so that they react once equities are
falling and then equities tend to recover.
If we shift liquidity forward 6
quarters we can see that the market "leads" anticipated"
additional liquidity by something similar.
This is very worrying now in that it suggests that equity price
appreciation could decelerate easily to -20 or even 40 percent
based on near zero central bank liquidity, assuming similar
multipliers to the post crisis period.
Some more dire predictions from Deutsche
on what will happen next to equity prices:
If we only consider the FX and FED
components of liquidity there appears to be a tighter and more
contemporaneous relationship with equity prices.
The suggestion is at one level still
the same, absent FED and FX reserve expansion,
equity prices look more likely
to decelerate and quite sharply.
The FED's balance sheet for
example could easily be negative 5 percent this time next year,
depending on how they manage the SOMA portfolio and would be
associated with further FX reserve loss unless countries,
including China allowed for a much weaker currency.
This would be a great concern for global (central
Once again, all of this assumes a status
quo for the QE out of Europe and Japan, which as we pounded the
table yesterday, are both in the process of being "timed out"
The tie out, presumably with the
"leading" indicator of other central bank action is that other
central banks have been instrumental in supporting equities in
largest of course being the ECB and BoJ.
If the FED isn't going doing its
job, it is good to know someone is willing to do the job for
them, albeit there is a "lag" before they appreciate the extent
of someone else's policy "failure".
Worse, as noted yesterday soon there
will be nobody left to mask everyone one's failure: the global
liquidity circle jerk is coming to an end.
What does this mean for bond yields?
Well, as we explained previously, clearly the selling of TSYs by
China is a clear negative for bond prices.
However, what Deutsche Bank accurately
notes, is that should the world undergo a dramatic plunge in risk
assets, the resulting tsunami of residual liquidity will most likely
end up in the long-end, sending Treasury yields lower.
...if investors believe that liquidity is likely
to continue to fall one should not sell real yields but buy them
and be more worried about risk assets than anything else.
This flies in the face of recent
concerns that China's potential liquidation of Treasuries for FX
intervention is a Treasury negative and should drive real yields
More generally the simple point is that falling reserves should
be the least of worries for rates - as they have so far proven
to be since late 2014 and instead, rates need to focus more on
The relationship between central bank liquidity
and the byproduct of FX reserve accumulation is clearly central
to risk asset performance and therefore interest rates.
The simplistic error is to assume that
all assets are treated equally.
They are not - or at least have not
been especially since the crisis.
If liquidity weakens and risk assets
trade badly, rates are most likely to rally not sell off.
It doesn't matter how many
Treasury bills are redeemed or USD cash is liquidated from
foreign central bank assets, U.S. rates are more likely to fall
than rise especially further out the curve. In some
ways this really shouldn't be that hard to appreciate.
After all central bank liquidity drives broader
measures of liquidity that also drives, with a lag, economic
we agree with DB that if the market
were to price in collapsing "outside" money, i.e. central bank
liquidity, that risk assets would crush (and far more than just
the 20-40% hinted above).
After all it was central bank
intervention and only central bank intervention that pushed the
S&P from 666 to its all time high of just above 2100.
However, we also disagree for one
simple reason: as we explained in "What
Would Happen If Everyone Joins China In Dumping Treasuries",
the real question is what would
everyone else do.
If the other EMs join China in
liquidating the combined $7.5 trillion in FX reserves (i.e.,
mostly U.S. Treasuries but also those of Europe and Japan) shown
... into an illiquid Treasury bond
market where central banks already hold 30% or more of all 10
Year equivalents (the BOJ will own 60% by 2018), then it is
debatable whether the mere outflow from stocks into bonds will
offset the rate carnage.
And, as we showed before, all else
equal, the unwinding of the past decade's accumulation of EM
reserves, some $8 trillion, could possibly lead to a surge in
yields from the current 2% back to 6% or higher.
In other words, inductively reserve
liquidation may not be a concern, but practically - when taking in
account just how illiquid the global TSY market has become - said
liquidation will without doubt lead to a surge in yields, if only
occasionally due to illiquidity driven demand discontinuities.
So where does that leave us?
Summarizing Deutsche Bank's
they confirm everything we have said
from day one, namely that the QE crusade undertaken first by the
FED in 2009 and then all central banks, has been the biggest
can-kicking exercise in history, one which brought a few years
of artificial calm to the market while making the wealth
disparity between the poor and rich the widest it has ever been
as it crushed the global middle class; now the end of QE is
And this is where Deutsche Bank,
which understands very well that the FED's tightening coupled
with Quantiative Tightening, would lead to nothing short of a
global equity collapse (especially once the market prices in the
inevitable tightening resulting from the BOJ's taper over the
coming two years), is shocked.
This reinforces our view that the FED is in
danger of committing policy error.
Not because one and done is a
non issue but because the market will initially struggle to
price "done" after "one". And the FED's communication skills
hardly lend themselves to over achievement.
More likely in our view, is
that one in September will lead to a December pricing and
additional hikes in 2016, suggesting 2s could easily trade to 1
This may well be an overshoot but it could imply
another leg lower for risk assets and a sharp reflattening of
the yield curve.
But it was the conclusion to Deutsche's
stream of consciousness that is the real shocker: in it DB's
Dominic Konstam implicitly ask out loud whether what comes next
for global capital markets (most equity, but probably rates as
well), is nothing short of a controlled demolition.
premeditated controlled demolition, and facilitated by
the FED's actions or rather lack thereof:
The more sinister undercurrent is
that as the relationship between negative rates has tightened
with weaker liquidity since the crisis,
there is a sense that policy is
being priced to "fail" rather than succeed.
Real rates fall when central banks
back away from stimulus presumably because they "think" they
have done enough and the (global) economy is on a healing
This could be viewed as a damning indictment of policy and is
not unrelated to other structural factors that make policy less
effective than it would be otherwise - including the
self evident break in bank multipliers due to new regulations
and capital requirements.
What would happen then?
Well, DB casually tosses an S&P trading
a "half its value", but more importantly, also remarks that what we
have also said from day one, namely that "helicopter
money" in whatever fiscal stimulus form it takes (even if
it is in the purest literal one) is the only remaining outcome after
a 50% crash in the S&P:
Of course our definition of
"failure" may also be a little zealous. After all
why should equities always rise
in value? Why should debt holders be expected to afford their
There are plenty of alternative
viable equilibria with SPX half its value,
longevity liabilities in default and debt deflation in
In those equilibria traditional QE ceases to work
and the only road back to what we think is the current desired
equilibrium is via true helicopter money via fiscal stimulus
where there are no independent central banks.
And there it is: Deutsche Bank saying,
in not so many words, what Ray Dalio hinted at, namely that
the FED's tightening would be the mechanistic precursor to a market
crash and thus, QE4.
Only Deutsche takes the answer to its
rhetorical question if the FED is preparing for a "controlled
demolition" of risk assets one step forward: realizing that at this
point more QE will be self-defeating, the only remaining recourse to
avoid what may be another systemic catastrophe would be the one both
Friedman and Bernanke
hinted at many years ago:
the literal para-dropping of money
to preserve the fiat system for just a few more days (At this
point we urge rereading footnote 18 in Ben Bernanke's
- Making Sure 'It' Doesn't Happen Here" speech)
While we can only note that the gravity
of the above admission by Europe's largest bank can not be
exaggerated - for "very serious banks" to say this, something epic
must be just over the horizon - we should add:
if Deutsche Bank (with
its €55 trillion in derivatives) is right and if the FED
refuses to change its posture,
exposure to any asset which has counterparty risk and/or whose
value is a function of faith in central banks, should be
effectively wound down.
While we have no way of knowing how this
all plays out, especially if Deutsche is correct, we'll leave
readers with one of our favorite diagrams: Exter's inverted pyramid.