Summary: Because it is a world trade currency there is enormous demand for more and more dollars across the globe. Not by foreign central banks but by financial institutions below them. Nor are these dollars conjured up by the Federal Reserve but by private banks taking advantage of fractional reserve banking. However, when banks cease to see many investment opportunities, start issuing less credit, and park their flexing power in only the most conservative assets, that creates a global dollar squeeze. That drives up its price, but it would be folly to mistake such a dollar appreciation as an indicator of US economic strength.
The World Trade Organization (WTO) reported that for the first time since 2009 global trade volumes have declined. During the third quarter of this year, the gross number of goods sent abroad from one country to another were fewer than the amount of those traded during the third quarter of last year. Though the negative was small, they always are to start with, it’s never a good thing when fewer goods are moved around.
Despite worldwide population expansion and the presumed gain of wealthier economies due to a boom everyone had been talking about, the WTO says that trade volumes peaked during that last third quarter. According to the same data, total trade values, that is, the monetary value of goods being traded factoring prices and currency translation, peaked the quarter before.
You may remember the second quarter of 2018. Central bankers remained in their full glory talking about the resurrected global recovery which they would use to return their policies to or near normal. It was a good time to be one for the first time in a long time. They made full use of the trend – as a means to dismiss the more and more frequent warning signs.
The dollar suddenly and sharply rose. Mere weeks later, May 29, a worldwide burst of what the FOMC would later downplay into some mysterious “strong worldwide demand for safe assets.”
Just a few weeks after that the eurodollar futures curve inverted and became what the WTO now shows is the first contraction in trade volumes since the Great “Recession.”
Trade wars, right?
It was around the same time that US President Donald Trump began to seriously threaten to put right what he saw as a Chinese wrong. During the past few decades, China had used unfair practices, it is claimed, including its currency to strip the US economy of its manufacturing pre-eminence. Offshored production had to come home, therefore tariffs on goods made in China.
The legitimacy of that argument aside, the dispute has happened and it did escalate into a real thing. The fears of a trade war and the trend toward protectionism eventually became actual tariffs and levies. But how does one connect them to the WTO’s data?
For one thing, as my colleague Joe Calhoun likes to (correctly and repeatedly) point out, trade wars don’t depress anything. The US demands from world markets what the US demands. If the US government makes Chinese goods artificially more expensive, then the US will simply get them from someone else.
We would expect, as Joe says, a global redistribution of trade. For every good China doesn’t produce because it has become relatively more costly for Americans to consume it there is a good someone else will at the right price. If not the Chinese, then the Germans or maybe Indians. Trade wars produce winners as well as losers.
Except, in this one we can’t find any winners. None.
Scour the WTO data on trade values or volumes and you’ll only find minus signs throughout all the export figures (as well as imports; figure that one out, too, while you’re at it). From Europe to Japan to Korea, all minus signs and often big ones (especially those last two Asian bellwethers). Even Canada and Mexico, the latter perfectly positioned to take advantage of trade redistribution, instead downturn and now negatives specifically in recent months.
As if to further confound the textbook analysis that passes in the mainstream, all of these places have been given the further “advantage” of a “stronger” dollar. So, in addition to President Trump making Chinese goods more expensive, China’s competitor’s goods have become that much cheaper for US businesses to import and consumers to buy – total demand which, we are told, has remained relatively steady with the unemployment rate as low as it is.
But it hasn’t worked out that way, either. According to the Census Bureau, US imports have tumbled.The primary reason Mexico’s exports are now contracting is that the US imports from Mexico were first.
The domestic trade data does confirm the negative effects of the trade war on China, as anyone would expect. The total value of goods inbound from that one country has collapsed, down by more than 23% year-over-year in October 2019 (the latest data) following hefty double-digit declines since earlier in the year.
But for China’s loss, there aren’t enough gains in other places to offset them. The US is importing less from everyone.
A lot less lately. As the export decline picks up across the world in the Autumn of 2019, the American economy is actually at the forefront. The total value of imports into the US fell by 3.0% year-over-year in August, -2.5% in September, and then an alarming -7.2% in October – the single most important month during any calendar year when foreign producers expect to cash in on the forthcoming Christmas shopping season.
In other words, while trade wars are indeed reallocating global value chains, creating relative winners and losers, there still must be something else overriding this reorganization which leaves everyone depressed and worn.
That can only be the work of the dollar.
Time and again, we see this as the most obvious yet misunderstood correlation in the financial, economic, and monetary universe. When the dollar goes up, trade first and then the whole global economy goes down. Including the US economy.
Given that, you would think there would be an extra-special initiative to figure out what exactly makes the dollar move as it does. Nope. Instead, it’s the same story time and again: central bankers and Economists who say it either reflects the strength of the US economy versus overseas (decoupling that pretty quickly resynchronized on the downside), interest rate differentials in our favor (the dollar first started to rise while interest rates did, and then it rose some more while they fell), or, for the more adventurous if not quite fully open-minded official, some version of flight to safety (which would benefit the US and would’ve at the very least increased inflation and demand).
The textbook explanation for the dollar’s behavior consistently falls short from each and every angle.
The key reason why is that there is no appreciation for how the world is short the dollar. I don’t mean short as in financial firms all over the world betting against it, hoping to profit by its falling value in the same way they would shorting a stock. The dollar short is instead a funding gap, and an enormous one that no one has yet sufficiently studied anywhere close to enough in order to make a decent guess as to how big it might be.
It stems from the requirements forced on it by being the reserve currency. Hardly anyone takes them into account. A reserve currency isn’t just the privilege of pricing primary commodities in your own denomination. It sure isn’t the petrodollar.
A reserve currency means that there has to be enough of it in all corners of the world such that vastly different systems can talk to each other, trade with each other, and connect with each other in vital ways (such as “capital flows”). They do so by virtue of the dollar being made available to everyone everywhere.
You can easily, fluidly translate local currency, finance, and trade by first turning them into dollars. And then whomever is on the other end, they do the same thing. The dollar sits in the middle of everything because it is universal.
This doesn’t just happen, though, it requires enormous financial resources to make it happen. The reason is as simple as the methods complex: neither the United States government nor the Federal Reserve prints the “dollars” that are used as this reserve. No, it is a credit-based system which means that banks create virtual liabilities which accomplish the same tasks as physical currency once did a very long time ago.
So long as banks are willing and able, they will and have supplied sufficient monetary resources to this vast offshore marketplace – the eurodollar space – to keep trade advancing, globalization a net positive, and the global economy full of so-called miracles.
When they aren’t so willing nor able, they tend to supply insufficient levels (which doesn’t necessarily mean contraction or declines; this is an important if tangential point to the discussion here; rate of change is what matters, which means that if the world demands, hypothetically, 10% more “dollars” this year than last year and banks are only willing to supply 5% more, that’s a big problem which still leads to all the negative results associated with textbook tight money conditions).
If the world requires so many of these offshore intermediating “dollars” and then traders from all over it can no longer easily get their hands on them, it’s really easy to work out what might happen to the price therefore exchange value of the dollar in that situation.
From the perspective of a global reserve currency, since global trade is its first function and use you can then appreciate why global trade is just where “dollar” woes show up first in the economy.
And it is only confirmed by all the price and market signals, as well as a large volume of data, that tell us about what those banks are doing as far as their intentions for the offshore dollar reserve. Liquidity indications have uniformly described the “strong worldwide demand for safe assets” as coming from that very sector, those very banks we would hope would be supplying reserve currency rather than hoarding the safest, most liquid instruments instead.
According to the Federal Reserve’s Z1 data, the Financial Accounts of the United States, starting in that pivotal second quarter of 2018 (the one with May 29) US Depository Institutions (L110) have added an astounding $241 billion of US Treasury securities (through Q3 2019, the one in which global trade is now contracting). That’s an increase of near 40%!
And it is on top of $248 billion of safe, liquid agency debt that depositories have also piled into their holdings. There are together a telltale sign of risk aversion that, for various reasons, isn’t going to be conducive to serving a growing global economy’s monetary needs. It is the most surefire way to turn globally synchronized growth into globally synchronized downturn exports first.
The change in UST holdings is something that others have noticed, as well. The BIS, for example, in its last Quarterly Review published earlier this month spends a few determined pages on September’s “shocking” repo disruption. The data they provide is quite similar to the Z1 figures, though shaped in its interpretation quite differently. This is what the BIS authors said about it:
“As repo rates started to increase above the IOER from mid-2018 owing to the large issuance of Treasuries, a remarkable shift took place: the US banking system as a whole, hitherto a net provider of collateral, became a net provider of funds to repo markets.”
They then connect the big, unsubstantiated assumption in the first sentence to focus in on the implications of the last sentence’s final clause – net provider of funds to the repo market – while completely glossing over the far more important, and corroborated, middle.
What was that thing about US banks hitherto something?
The BIS begins where everyone else had, under this suspicion that the federal budget was the reason for repo rates rising (“too many Treasuries” that have to be funded in repo). And it is looney, because even its data shows the big change began several quarters before the point they focus on.
Several weeks ago I pointed that out in response:
“The BIS has interpreted its data to mean the biggest US banks had become important sources of funds in repo. One can also interpret the same data to mean something else; a different take which is actually consistent with the facts. Market prices. Dollars and Treasuries (bunds, inflation expectations, interest rate swaps, eurodollar futures, etc.) If these banks were “hitherto a net provider of collateral” but no longer are, are we really just supposed to leave it at that? After all, if a very important source of available collateral (securities lending) suddenly becomes unavailable, that sounds like a more immediate point of real weakness than a dismissible non-factor that only showed up in September 2019 by technical accident.”
And my point is further aided by both the BIS data as well as the Z1 figures – and not just those taken from US Depositories.
One other massive player in the domestic credit market system is ROW, or rest of world. This is foreign financial bank and non-bank agents which supply credit to the US, in dollars, as well as take in funding for that supply of credit as well as other supplies of credit in other places. Also in dollars.
What the Z1 data for ROW tells us is not what the BIS interprets. Beginning in the third quarter of 2018, ROW’s repo liabilities began to rise before exploding in Q2 and Q3 2019. The total increase is $359 billion, or 40%.
It tells us that foreign banks operating through US subs have been borrowing every scrap of repo funding that they can find during the last year, year and a half or so. But why?
Z1 also shows that during the same time other types of US$ funding had slowed and even contracted – during Q4 2018’s landmine, for example, total non-repo ROW US$ liabilities crashed by more than 9% year-over-year, a disappearance of about $1.2 trillion (with a “T”) going back to Q4 2017. These are everything from deposit liabilities to foreign direct investment, along with a healthy dose of bonds and, as usual, a big chunk of “other.”
Those dollar routes started (Q1 2018) downhill at the same time the BIS repo data says US banks “hitherto a net provider of collateral” increasingly were not. What followed was: surprising global market liquidations in January 2018, the dollar rising by April, then that global collateral call on May 29, curve inversions over the next few weeks, and the ROW sector more and more depending upon repo as its funding of last resort.
All before the end of 2018.
And while all that was taking place, Jay Powell was smiling widely for the cameras about his US inflationary breakout even though global trade and the global economy had already begun their descent. The strong worldwide demand for safe assets directly tied to the increasingly “strong” dollar he couldn’t and wouldn’t explain.
To clarify all the intricacies of all these various moving parts would require even more space than I’ve already consumed (and I’ve done so, in pieces, over the past few months and years). Suffice it to say, between collateral changes, bank changes, and the like, there arose a substantial global financial imbalance a lot of which came to be outed by the repo market.
The net result was a growing dollar shortage which, given the global dollar short, could only produce losers. The dollar’s exchange value rose because from that point forward nothing would be strong. Trade wars simply didn’t matter that much.
If the global economy is on the mend, as is the current mood predicated largely on the sudden appearance of “trade deals”, then the latest trade data and liquidity indications wouldn’t be what we find in them. Shorts and shortages, still souring rather than soaring. Who can win at that?
By Jeffrey Snider
Source: Real Clear Markets