To be sure, there’s been no shortage of media coverage regarding the collapse in crude prices that’s unfolded over the course of the past year. Similarly, it’s no secret that commodity prices in general are sitting near their lowest levels of the 21st century.
When Saudi Arabia, in an effort to bankrupt the US shale space and tighten the screws on a recalcitrant Moscow, endeavored late last year to keep oil prices suppressed, the kingdom killed the petrodollar, a move we argued would put pressure on USD assets and suck hundreds of billions in liquidity from global markets.
Thanks to the fanfare surrounding China’s stepped up UST liquidation in support of the yuan, the world is beginning to understand what we meant. The accumulation of USD assets held as FX reserves across the emerging world served as a source of liquidity and kept a bid under things like US Treasurys. Now that commodity prices have fallen off a cliff thanks to lackluster global demand and trade, the accumulation of those assets slowed, and as a looming Fed hike along with fears about the stability of commodity currencies conspired to put pressure on EM FX, the great EM reserve accumulation reversed itself. This is the environment into which China is now dumping its own reserves and indeed, the PBoC’s rapid liquidation of USTs over the past two weeks has added fuel to the fire and effectively boxed the Fed in.
On Tuesday, Deutsche Bank is out extending their "quantitative tightening" (QT) analysis with a look at what’s ahead now that the so-called "Great Accumulation" is over.
"Following two decades of unremitting growth, we expect global central bank reserves to at best stabilize but more likely to continue to decline in coming years," DB begins, before noting what we outlined above, namely that the "three cyclical drivers point[ing] to further reserve draw-downs in the short term [are] China’s economic slowdown, impending US monetary tightening, and the collapse in the oil price."
In an attempt to quantify the effect of China’s reserve liquidation, we’ve quoted Citi, who, after reviewing the extant literature noted that for every $500 billion in EM FX reserve draw downs, the effect is to put around 108 bps of upward pressure on 10Y UST yields. Applying that to the possibility that China will have to sell up to $1.1 trillion in assets to offset the unwind of the great RMB carry and you end up, theoretically, with over 200 bps of upward pressure on yields, which would of course pressure the US economy and force the Fed, to whatever degree they might have tightened by the time China’s 365-day liquidation sale ends, to reverse course quickly.
Deutsche Bank comes to similar conclusions. To wit:
The implications of our conclusions are profound. Central banks have accumulated 10 trillion USD of assets since the start of the century, heavily concentrated in global fixed income. Less reserve accumulation should put secular upward pressure on both global fixed income yields and the USD. Many studies have found that reserve buying has reduced both bund and US treasury yields by more than 100bps. For every $100bn (exogenous) reduction in global reserves, we estimate EUR/USD will weaken by ~3 big figures.
Declining FX reserves should place upward pressure on developed market yields given that the bulk of reserves are allocated to fixed income. A recent working paper by ECB staff shows that the increase in foreign holdings of euro area bonds from 2000 to mid-2006... is associated with a reduction of euro area long-term interest rates by about 1.55 percentage points, in line with the estimated impact on US Treasury yields by other studies. On the short-term impact, one recent paper estimates that “if foreign official inflows into U.S. Treasuries were to decrease in a given month by $100 billion, 5- year Treasury rates would rise by about 40–60 basis points in the short run”, consistent with our estimates above. China and oil exporting countries played an important role in these flows.
Which of course means the Fed is stuck:
The current secular shift in reserve manager behavior represents the equivalent to Quantitative Tightening, or QT. This force is likely to be a persistent headwind towards developed market central banks’ exit from unconventional policy in coming years, representing an additional source of uncertainty in the global economy. The path to “normalization” will likely remain slow and fraught with difficulty.
Put simply, raising rates now would be to tighten into a tightening.
That is, the liquidation of EM FX reserves is QE in reverse. The end of the great EM FX reserve accumulation means QT is set to proliferate in the face of stubbornly low commodity prices and decelerating Chinese growth. And indeed, if the slowdown in global demand and trade turns out to be structural and endemic rather than cyclical, the pressure on EM could continue unabated for years to come. The bottom line is this: if the Fed hikes into QT, it will exacerbate capital outflows from EM, which will intensify reserve draw downs, necessitating a quick (and likely embarrassing) reversal of Fed policy and perhaps even QE4.