Most of the post-Lehman era has been characterized by unprecedented easy monetary policy meant to inflate asset prices, and sure enough after 705 rate cuts, and $12.4trillion in QE, the S&P is just shy of its all time highs. However, over the past year, a different dynamic has taken place: the Fed's tightening cycle and ongoing rate hikes have resulted in a sharp drain of USD-liquidity across the globe.
Meanwhile, with the ECB set to end its QE and the BOJ taking tentative steps toward tightening while engaging in a shadow taper of its own QE, central bank balance sheets are set to shrink for the first time since the financial crisis.
It is this tightening in financial conditions in general, and dollar liquidity in particular that ultimately has been the catalyst that led to a near record divergence in FX volatility between emerging markets and developed nations, incidentally that last time we saw such deltas was just after 9/11 and the great financial crisis.
While leads us to the bigger problem: as the dollar becomes more attractive and as carry trades collapse, emerging markets are forced to respond to currency weakness with interest rate hikes to stem capital outflows. And, most concerning as the chart below shows, the pace of global central bank rate hikes has already visibly jumped since EM weakness began in February this year. In fact, the current pace of rate hikes is almost on par with the pre-Lehman period - a time where policy makers were trying to slow a global economy that felt too good to be true.
And as Bank of America's Barnaby Martin writes, not only will global economic growth slow down as a result of monetary tightness and higher interest rates, but as a result of the rapid pace of central bank hikes across the globe, "crowding" into risky assets will inevitably slow.
More ominously, it's not just an EM phenomenon: "dollar strength has emerged as a major negative for European markets too." As the chart below shows, retail inflows into Euro credit funds have fizzed-out this year, and this has coincided with the period of Dollar strength from March onwards in '18. Coupled with very attractive front-end rates on the Treasury curve, European retail money is simply leaking to the US market now and explains not only the persistent weakness of the Euro - despite the ECB's recent taper announcement - but also the ongoing decoupling between the US and the rest of the world.