Over the weekend, we showed why according to Macquarie strategist Viktor Shvets, the "biggest risk facing investors over the next 12 months" was an intense appreciation in the US dollar. The key reason behind the thesis was simple: a sharp reduction in dollar supply has been observed as the Fed destroys liquidity by shrinking its balance sheet resulting in a contracting US monetary base, coupled with the seeming inability of the US to significantly widen its CA deficits (despite public sector dis-saving).
This was shown in the chart below:
Now, in a strategy note sent to us by Neels Heyneke and Mehul Daya of South Africa's Nedbank, the analysts reach the same conclusion as Shvets, claiming that we are now entering "the beginning of a prolonged risk-off phase as global dollar liquidity has started losing momentum."
Just like for Macquarie, Nedbank agrees that "it's all about the dollar", explaining that there is nothing more important than "getting the dollar right." Here's why:
The US dollar is still the dominant global currency, and a stronger dollar is an indication of tighter global financial conditions.
If this is the case now again, and we believe it is, then we can expect real rates (term/risk premium) to rise, which would be negative for risk assets. The tighter financial conditions would also be deflationary by nature.
We therefore expect the US10yr to rally (continuation of the 30yr bull trend), reflecting the deflationary forces of a stronger dollar and contraction in the Global $-Lliquidity – this would not bode well for risk-assets (like SA bonds/FX /equities).
One can see why Nedbank is concerned with its version of a chart we first presented three months ago:
Meanwhile, once again echoing Macquarie, Nedbank then points out that its own global $-Liquidity indicator has been losing momentum "due to the tightening monetary conditions by the US Federal reserve (and as US current deficit shrinks)", the same reasons highlighted by Shvets previously, and largely repeating the same warning as we noted before, Heyneke writes that as "dollar liquidity slows down, it is likely to unwind the extreme positioning and enforce a strong dollar (ie de-risking)."
To be sure, if indeed a significant dollar repricing is in the works, the first place one would see the turmoil - is the same place we already have seen turmoil in response to the recent spike in the dollar: emerging markets.
A contraction in Global $-Liquidity, as reflected by a stronger dollar and tighter financial conditions, is likely to correct the distortion between deteriorating EM fundamentals and the carrytrade (portfolio allocation to EM).
And while we pointed out last week that EM had just suffered the biggest outflows since December 2016...
... should dollar strength continue, that would be just the beginning of a sharp rotation in capital away from EMs.
Ok fine... but we knew all of this already; where the Nedbank report differs from Macquarie, however, is that it lays out what its authors believe may be a trigger point, or rather "canaries in the coalmine" to determine just when the Emerging Markets inflection point hits.
As Heyneke writes, there are many "canaries" that are starting to "fall over", which is why the strategist is "deeply concerned about current market conditions. We are faced with very large risk-on positions (ie record net long positions in oil, copper, EUR/USD etc)."
The first "canary" is that the Bloomberg EM FX carry index has finally broken out of the bull trend first launched in early 2016 with the Shanghai Accord. Here's Nedbank:
The carry index is an important “canary” to monitor. The index has broken out of the bull trend at 260 and has rallied from the 255 neckline on Friday to test 260 from below.
The next few days will be important, as a consolidation below 260 would confirm a major reversal.
A break below the neckline at 255 and below the wave-A high at 252 would project substantial downside (to below the (red) wave-C low of early 2016). The MACD has also confirmed the break out of the bull trend.
The second "canary" is even more ominous, as it is not merely some squiggle on a chart but a direct market response to funding conditions, and suggests that a dollar shortage is already spreading among Emerging Markets.
As Nedbank shows in the chart below, the Bloomberg Barclays EM local and USD denominated debt spreads "has taken out the highs of 2016 and has broken into the late-2016 lows", suggesting that EM funding conditions are now reminiscent to the days when every single night Chinese stocks would crash as traders panicked over China's ongoing devaluation.
Here, Heyneke warns that the latest move sharply higher in yields "is likely to be more than just a correction phase and should target the neckline at 5.50%" for one reason:
The world, and in particular emerging markets, has been on a dollar debt binge – one that has issued over $3.5.tn (rest of world $10tn) in dollar debt. Hence our concern that a slowdown in dollar liquidity would not bode well for dollar-indebted nations/corporations.
Putting it together, Nedbank concludes that "if the EM currencies fail over the next few days to break back into the bull trend that has been in place since the start of 2016", or in other words, if the Dollar move higher continues, "then it is just a matter of time in our opinion before the EM currencies force foreign investors out of the EM markets."
That, incidentally, is also part of what Macquarie dubbed the "biggest danger facing investors over the next twelve months."