UK, Japanese, and US$ Liquidity
(December 8, 2011)
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In our November 4, 2011 commentary (“Bullish on the US Dollar”), we became bullish on the US dollar for the first time in a while, as global liquidity—measured by the amount of US$ available in the world—was quickly declining. US$ liquidity is an important indicator for both global liquidity and for predicting the strength of the US$, as the vast majority of the world's trade is still conducted in US dollars. Just as important, there is no alternative reserve currency, given the structural flaws in the Euro (which we have previously discussed, and that are now becoming obvious to the mainstream media) and the fact that the Chinese capital account is still closed. In addition, virtually all major economies are in an easing bias, which should logically add to US$ strength.
Similar to a game of musical chairs, the “marginal” U.S. dollar borrower (e.g. Thailand in July 1997, Brazil in 1998, and Argentina in 2002) will be cut off if there is a declining supply (or a decreasing growth in supply) of U.S. dollars—resulting in a liquidity squeeze in major parts of the world (the recent plunge in the Indian Rupee is a prime example). In such a scenario, the U.S. dollar and U.S. assets (e.g. Treasuries) would outperform. A very reliable indicator/measure of a potential US$ liquidity squeeze is the growth in the amount of foreign central bank reserves held in the custody of the Federal Reserve. Whenever the rate of growth of foreign assets held at the Federal Reserve banks decreased substantially, the US$ has almost always rallied—typically resulting in some kind of foreign/global financial crisis. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value. The following chart shows the level of foreign reserves vs. the annual change in foreign reserves (from January 1982 to November 2011):
Ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard. Therefore, as world trade expanded, the demand for dollar has increased—and with it, the increase of foreign dollar reserves held at the Federal Reserve Banks. It is interesting to note that various financial crises or economic recessions (see above chart) have usually occurred when the annual change of dollar reserves is slowing down or experiencing negative growth. This growth rate has been as high as 36% in August 2004 but it has been decreasing since the beginning of 2010. The annual growth rate for October 2011 declined to just 3.1%--its lowest growth rate since March 2002! During November, year-over-year growth popped back up to 3.3%, but remains near a multi-year low. While the US$ bilateral swaps created by the world's six major central banks last week will alleviate this burden (and thus be less bullish for the US$), it is a temporary solution—as what the Euro Zone needs is significant, structural reforms, likely coupled with some kind of debt relief or devaluation. As US$ liquidity growth declines, other crises will inevitably pop up—and as such, the European sovereign debt crisis is likely to get worse, and with the ECB easing further, the Euro will decline against the US$. In the meantime, the creation of US$ bilateral swaps will provide some support for global liquidity.
In the meantime, the Bank of England is rumored to raise its quantitative easing target even more. Its current limit of 275 billion pounds was agreed upon in mid-October. Since then, the Bank of England has engaged in about 5 billion pounds of weekly asset purchases, almost as much as its initial pace from March to early July 2009 (see below chart). Given the lack of private sector lending and the ongoing European Sovereign Debt Crisis, I expect the Bank of England to expand its QE program again early next year. In the meantime, this new limit (the size of its balance sheet is currently 240 billion pounds and thus 35 billion pounds below its limit) allows the Bank of England additional flexibility in combating a slowing economy and the risk of another global liquidity shock (although it's a drop in the bucket relative to Europe's overall funding needs):
Somewhat encouragingly, while liquidity in Japan isn't as loose as it was in the aftermath of the March 11th earthquake, its monetary base has recently crept up. From month-end October to month-end November 2011, the year-over-year change in the Japanese monetary base increased from 17.0% to 19.5%--although it's still down from 23.9% at the end of April—as shown in the following chart:
While all of these developments are encouraging from a global liquidity standpoint, most of the burden still falls on Germany, France, and of course the ECB. I believe the willingness of Germany to shoulder a significant part of the debt burden is key to maintaining the Euro monetary union, given the lack of structural growth in many of the peripheral countries and the unsustainability of their debt burdens, short of a mass wealth tax in Greece and Italy. The incredible household net worth on the Italy may actually be an obstacle to a quick solution, as Italy's wealth simply does not morally justify IMF funding nor a mass transfer of wealth from Germany. As such, investors should continue to be cautious despite the latest uptick in global liquidity.
Henry To, CFA, CAIA