Doug Noland: Global Lender of Last Resort

It is a central tenet of Bubble Analysis that “things get crazy at the end of cycles.” The confluence of late-cycle excess/fragility along with aggressive policy interventions (meant to hold crisis at bay) fosters a precarious dynamic of emboldened speculators operating in ultra-loose financial conditions. Especially after the Fed expanded its balance sheet by a few Trillion in not many weeks, confidence became stronger than ever in the central bank mantra of “whatever it takes” to sustain inflating market prices. Speculative Melt-Up.

It was integral to my analysis that the Fed’s restart of QE last September – so-called “insurance” stimulus – stoked “terminal phase” speculative excess at home and abroad.


Understandably, attention remains focused on the dominant U.S. tech stocks, record highs in Nasdaq, sector rotation opportunities, and the Robinhood phenomenon. It’s a mania, after all. There are as well stimulus negotiations and the administration’s determination to pound away at China – non-bullish developments too easily disregarded.

Crisis memories and concerns, meanwhile, fade with astonishing alacrity. These days, attention has shifted completely away from the global financial “plumbing” that became utterly clogged up in March. Did central banks successfully flush through the issue, or has the matter instead been left to swell into an only more problematic future blockage?

Fortunately, there are some determined financial journalists still pursuing one of the more significant stories of our lifetimes. There was Monday’s article from Bloomberg’s Rich Miller and Jesse Hamilton: “Fed Is Headed for a Clash With Hedge Funds, Other Shadow Banks.” Also Monday, from The Wall Street Journal’s Serena Ng and Nick Timiraos: “Covid Supercharges Federal Reserve as Backup Lender to the World.”

August 3 – Bloomberg (Rich Miller and Jesse Hamilton): “The Federal Reserve and other central banks are heading for a collision with shadow lenders — the firms with a sinister nickname that are increasingly dominating global finance. Even as policymakers struggle to reopen their economies in the midst of the coronavirus pandemic, they’ve launched a review of what went wrong with markets in March, when a worldwide dash for cash by investors nearly crashed the financial system and forced unprecedented rescue actions by central banks. Their focus is on loosely regulated money market and hedge funds, mortgage originators and other entities. Already, some watchdogs have pointed to highly leveraged trades involving U.S. Treasuries as one source of the turmoil. ‘In many cases they have reached systemic importance,’ Bank for International Settlements General Manager Agustin Carstens said of the non-banks. He added that it’s time to move toward more regulation. There’s a lot at stake should the scrutiny lead to tougher oversight. The alternative financiers are major providers of credit to households and companies, making their smooth functioning critical to the health of financial markets and the economy.”

March’s financial dislocation – the “seizing up” of global markets – corroborated the global Bubble thesis. International data along with myriad anecdotes over recent years have pointed to an unprecedented post-crisis expansion of global leveraged speculation. March saw the powerful explosion of de-risking/deleveraging swiftly bring global finance to its knees.

It was integral to my analysis that the Fed’s restart of QE last September – so-called “insurance” stimulus – stoked “terminal phase” speculative excess at home and abroad. The above Bloomberg article references the Bank of International Settlements’ (BIS) 2020 Annual Economic Report. I’ve extracted below:

BIS: “As a precursor to this episode, dislocations in the US repo market in September 2019 involved much the same players, with dealer balance sheet constraints again being a contributing factor. Back then, repo demand from hedge funds to maintain arbitrage trades between bonds and derivatives contributed to a repo funding squeeze. With dealer banks holding already large US Treasury positions, reluctance to accommodate the higher demand for repo funding compounded the shortage and led to a sharp spike in the secured overnight financing rate (SOFR). The Federal Reserve had to step in to provide ample repo funding and absorb Treasury collateral from the market.”

BIS: “The severe [March] dislocation in one of the world’s most liquid and important markets was startling. It reflected a confluence of factors. A key driver was the rapid unwinding of so-called relative value trades, which involve buying Treasury securities funded using leverage through repos while at the same time selling the corresponding futures contract. Investors, typically hedge funds, employ such strategies to profit from differences in the yield between cash Treasuries and the corresponding futures. Given that these price discrepancies are typically small, relative value funds amplify the return (and, by extension, losses) using leverage.”

An even greater dislocation erupted in international markets for dollar-denominated bonds and dollar-related derivatives. This followed years of unprecedented growth in dollar debt globally, along with corresponding levered speculation in these instruments (and related derivatives).

BIS: “Over the past two decades, the use of the US dollar in global financial transactions has ballooned. US dollar liabilities of non-US banks outside the United States grew from about $3.5 trillion in 2000 to around $10.3 trillion by the end of 2019. For non-banks located outside the United States, they have grown even more rapidly and now stand at roughly $12 trillion, almost double what they were a mere decade ago. There is also a significant amount of off-balance sheet dollar borrowing via FX derivatives, primarily through FX swaps. Funding pressures therefore tend to show up in these markets.”

BIS: “A significant portion of the international use of major reserve currencies, such as the US dollar, takes place offshore. Dollar liabilities (ie loans and debt securities) on the balance sheets of banks and non-banks outside the United States amounted to over $22 trillion at end-2019. On top of this, off-balance sheet US dollar obligations incurred via derivatives such as FX swaps were even larger, with estimates ranging up to $40 trillion. An FX swap allows an agent to obtain US dollars on a hedged basis, which is functionally equivalent to collateralised borrowing.”

With “non-bank” dollar-denominated liabilities having doubled over the past decade to $12 TN – and FX swaps expanding to an estimated $40 TN – you’re talking massive proliferation of “offshore” dollar obligations. March’s “seizing up” confirmed that way too much speculative leverage had accumulated internationally. This helps explain why massive ($3 TN) Federal Reserve liquidity injections were required to reverse de-risking/deleveraging dynamics. As the BIS stated: “With the GFC [great financial crisis] as precursor, the role of the Federal Reserve as a global lender of last resort has been further cemented.”

August 3 – Wall Street Journal (Serena Ng and Nick Timiraos): “When the coronavirus brought the world economy to a halt in March, it fell to the U.S. Federal Reserve to keep the wheels of finance turning for businesses across America. And when funds stopped flowing to many banks and companies outside America’s borders—from Japanese lenders making bets on U.S. corporate debt to Singapore traders needing U.S. dollars to pay for imports—the U.S. central bank stepped in again. The Fed has long resisted becoming the world’s backup lender. But it shed reservations after the pandemic went global. During two critical mid-March weeks, it bought a record $450 billion in Treasurys from investors desperate to raise dollars. By April, the Fed had lent another nearly half a trillion dollars to counterparts overseas, representing most of the emergency lending it had extended to fight the coronavirus at the time. The massive commitment was among the Fed’s most significant—and least noticed—expansions of power yet.”

The Fed’s interventionist leap into corporate bonds and ETFs clearly exerted profound market impact. Suddenly, the Fed was viewed as providing a direct liquidity backstop, boosting the attractiveness (and prices!) of corporate Credit and fixed-income ETFs in particular. Not generally as appreciated – yet arguably more momentous – the Fed’s aggressive liquidity measures and expansion of swap lines with the international central bank community were seen as creating a liquidity backstop for the massive offshore markets for dollar-denominated instruments (bonds and derivatives).

In both domestic corporate Credit and international finance, Fed and central bank measures reversed de-risking/deleveraging dynamics. At home and abroad, speculative flows resumed, financial conditions loosened, debt issuance mushroomed, and markets recovered. Global finance – markets and policymaking – became only more closely synchronized. As noted by the BIS: “It established the Fed as global guarantor of dollar funding, cementing the U.S. currency’s role as the global financial system’s underpinning.”

It is a central tenet of Bubble Analysis that “things get crazy at the end of cycles.” The confluence of late-cycle excess/fragility along with aggressive policy interventions (meant to hold crisis at bay) fosters a precarious dynamic of emboldened speculators operating in ultra-loose financial conditions. Especially after the Fed expanded its balance sheet by a few Trillion in not many weeks, confidence became stronger than ever in the central bank mantra of “whatever it takes” to sustain inflating market prices. Speculative Melt-Up.

There is today no doubt in the marketplace that the Fed, in the event of market instability, would quickly replay March’s crisis operations. Markets see nothing inhibiting Fed intervention measures. The sanguine view holds even for the Federal Reserve’s extraordinary international crisis operations. From the above WSJ article: “The risks to the Fed are minimal given that it is dealing with the most creditworthy nations and the most advanced central banks.”

Last week’s CBB attempted to explain how the unsound U.S. Bubble Economy structure ensured massive ongoing fiscal and monetary support. From an international financial markets perspective, Bubble Market Structure will also require unrelenting monetary stimulus – zero rates, open-ended QE, international swap arrangements, and other crisis-fighting tools.

Over the past two months, the Swiss franc has gained 5.5% versus the dollar. The euro is up 4.4%. The Dollar Index has sunk to a two-year low. Gold is up about $350, or 20%, in two months. Silver has surged almost 70%. And despite surging risk markets, safe haven 10-year Treasury yields have sunk 30 bps in two months to record lows.

Are the safe havens signaling acute fragility in this global Bubble of leveraged speculation and the inevitability of only more aggressive Federal Reserve balance sheet growth “as global guarantor of dollar funding”? Understandably, Fed officials must remain quite alarmed by the scope of March’s market dislocation – and even more so by the prospect of operating as lender of last resort for dysfunctional and chaotic global securities, funding and derivatives markets.

Bloomberg: “The tumult highlighted the vulnerabilities of non-banks, Fed Vice Chairman for Supervision Randal Quarles wrote in a July 14 letter to central bank chiefs and finance ministers of leading nations. As head of the Financial Stability Board, he’s promised to deliver a report on the mayhem to leaders of the Group of 20 nations by November.”

The Bloomberg article also quoted Janet Yellen calling for a new Dodd-Frank. I’ve pulled her more complete quote from a Brookings Institute event, “A Decade of Dodd-Frank” (quoted by doddfrankupdtate.com): “When we do recover, I think we should reflect on the lessons from the crisis. I personally think we need a new Dodd-Frank. We need to change the structure of FSOC (Financial Stability Oversight Council) and build up its powers to be able to deal more effectively with all of the problems that exist in the shadow banking sector. I think the structure is inherently flawed. I think the agencies need a definite financial stability mandate.”

Chair Yellen should have been more focused on the Fed’s financial stability mandate. The global “shadow bank” Bubble inflated tremendously during her watch, fueled by the Yellen Fed’s misguided postponement of policy normalization. Bubble fragilities then quashed Powell’s normalization plans. It was clear some years back that Dodd-Frank had worked to hasten the expansion of “off-shore” non-bank Credit and leveraged speculation.

And from Federal Reserve governor Lael Brainard: “I absolutely think the kinds of risk that Janet talked about in the nonbank financial sector were not only predictable but well-documented and can be subject to an expansion of the regulatory perimeter… I do think that very quickly, once we have come through this very challenging moment, it will be time to look back and make the necessary changes to those areas where the work of financial reform is incomplete. And to be fair, there will always be new areas.”

The Fed recognizes it has a huge problem. And much like President Trump’s calculated attacks on China, the markets believe the Fed might talk tough with respect to “shadow bank” excesses but would never risk measures that might destabilize fragile global markets. We’re now less than three months to election day. Ebullient markets can for now assume comfort with the possibility of a President Biden. But if the Democrats complete a full sweep, expect impetus for a new Dodd-Frank with a focus on reining in the hedge funds and “shadow banks” more generally.

For now, bubbling stocks and corporate Credit focus on short-term prospects for ongoing momentum. Safe havens, meanwhile, have become fixated on the inevitability of crisis and mayhem. And while most dollar-denominated EM bonds remain in speculative melt-up mode, Turkey is back in crisis. The Turkish lira dropped another 4.2% this week to an all-time low versus the dollar (down 18.3% y-t-d). Turkey’s 10-year dollar bond yields jumped 17 bps to a 10-week high 7.48%. Offshore lira borrowing rates surged to 1,000% annualized this week, as Turkey’s markets approach the breaking point (facing huge debt dollar debt maturities with rapidly depleting international reserves).

BIS: “The Fed’s aggressive overseas lending has injected it into the world of foreign policy: Not every country gets equal access to the Fed’s dollars. Turkey, for example, has appealed unsuccessfully for dollar loans from the Fed to support its sinking currency…”

The dollar has a long history as “the world’s reserve currency.” Over the past decade, it also became the prevailing currency for a historic Bubble in global leveraged speculation. I’m sticking with the view that the global Bubble has been pierced (analogous to subprime in Spring 2007). The U.S. flooded the world with dollar balances – that could be used for leveraged speculation in higher-yielding dollar-denominated EM debt. EM central banks would then predictably “recycle” these Bubble Dollars right back into U.S. securities markets. It was miraculous, went to egregious excess, and is now winding down.

We saw in March that this process badly malfunctions in reverse. And while Trillions of central bank liquidity sparked a market rally, I expect the next phase of global deleveraging to commence in the coming months. There is a long list of vulnerable countries that accumulated too much debt – too much denominated in dollars. It’s worth noting that the Brazilian real declined 4.0% this week, with the Chilean peso down 3.8%, the South African rand 3.2%, and the Colombian peso 1.1%.

It’s not difficult to envisage a scenario where the Fed finds itself stuck deep in geopolitical muck. Pressure to lend to our allies and avoid the others – a process that would seemingly accelerate the transformation to a more bi-polar world. I’ve for a while now pondered the relationship between the Fed and PBOC when things turn sour between Washington and Beijing. There are enormous amounts of dollar-denominated debt in China and Asia – too much held by leveraged speculators.

The bursting of the global dollar debt Bubble will likely coincide with a major deterioration in the dollar’s value as the world’s reserve currency. And this seems like a pretty good explanation for surging precious metals prices. Markets these days see nothing that could keep the Fed from aggressively employing endless QE necessary to sustain market Bubbles. There are myriad complexities and challenges being ignored today by the risk markets.

Original Post 8 August 2020


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