Currency Markets and The Fed (w/ Raoul Pal & James Aitken)
RAOUL PAL: I want to talk through the currency markets now. Then we'll move on to different scenarios in how this could play out, because it's a very uncertain world. Talk me through your phasing of the currency markets, how you see this play out. We all understand that the dollar is a problem. How do you think this plays out? JAMES AITKEN: Well, we've seemed to have inverted that famous anecdote from Secretary Connolly in the 1970s. Remember when Connolly was negotiating the end of Bretton Woods and he famously said, add dollar, your problem. Well, right now, it seems that the United States say add dollar, our problem. We will be the world's central bank. We will downstream dollars at a fair price wherever they're needed in unlimited quantities to prevent the financial system tipping over on itself. Now, if you consider that, if you consider what the Fed's doing, and if you consider what we discussed earlier about the amount of Treasury issuance to come, you'd say yourself, my gosh, that's creating the conditions for a very weak dollar. Now, to be clear, I'm not overlooking all the dollar indigestion that we've seen over the past couple of months, and which, broadly speaking, has calmed down a lot so that the plumbing is starting to work much better. It's not perfect, but it's much better. The Fed is shoving money, shoving dollars out the door. That seems to be working, but the dollar is not weakening. Here's where we need to get a little bit technical and down into the plumbing. Let's think about this scenario. The Fed is offering dollar liquidity to other central banks at a price of three-month OAS plus about 25 basis points, which let's say for simplicity, 35, or 40 basis points all in. Now, that's very cheap dollars, and unsurprisingly, that has had a tremendous impact on a lot of dollar funding spreads around the world. The cross currency basis swaps, which have developed quite some fame over the past several years, there's now a discount for dollars as opposed to a premium. It's spectacular. Then the next step back, we have the Fed's commercial paper funding facility, which doesn't get up and running until April 14th. The initial cost of this commercial paper funding facility, which need I remind subscribers, is a short term unsecured loan, commercial paper, in original cost, I think advised by Mnuchin which was a ridiculous three-month OIS plus 220, which is stupid. They kept the cost to three-month OIS plus 110, which I still argue is stupid, especially-- sorry, to be clear, it's not stupid, it's unnecessarily high to be fair to them. You have dollar liquidity going out the door via central banks at 35 or 40 basis points via the dollar swap lines, and you have a commercial paper funding facility at three-month OIS plus 110, 120 basis points when you factor in the thing. That's very, very high. The problem here to think about exchange rates is that the cost of this commercial paper funding facility is acting as a floor to Dollar LIBOR. The one price of dollar funding, if we want to think about it this way, that looks completely out of line on my screen is three-month Dollar LIBOR, which continues to set let's say simplistically, around 130, 135 basis points. That's because I'd argue that the commercial paper funding facility hasn't started yet. The cost of it is too high, and we'll have a clearer picture on dollar funding conditions from April 14th onwards, and you can tell where I'm going with this. Up until April 14th, if Dollar LIBOR is still fixed in, three-month Dollar LIBOR still fixed in at 130, 135 basis points, it's going to be very hard for the dollar to come down. Even though there's dollars going out the door and we're re-liquefying the plumbing, 135 basis points compared to negative numbers in some other jurisdictions, the dollar's going to remain sticky. I think after April 14th, Dollar LIBOR is going to ease off, maybe through May and June. On balance, my suspicion is that may tend to undermine the dollar. I don't know yet but I'm watching carefully. RAOUL PAL: Because one of the things that still goes through my head, I'm still very much in the camp that the dollar goes much higher. My fear within this is that the swap lines are just an alleviation of a symptom. It's taking a headache tablet for the flu. That's all it's doing. The actual problem is Chinese, South Korean, Indian, Brazilian and a bunch of corporates have a lot of dollar debts. Now, the problem is in this world, as you know it, flows from the central bank to the banking system. BOJ gets a bunch of these or whichever central bank it is, they give it to the banking system. The banking system, utilizes what it can, and obviously, in a world like this, you only give the dollars to the best credit. It feels like game of musical chairs, where the worst creditors are trying to get their dollars, trying to get the chair and so I worry that there's a negative convexity in this market that if the dollar goes up, it goes up a lot. JAMES AITKEN: Well, we certainly saw a hint of that in the past month, didn't we? RAOUL PAL: Yes, that was scary for a minute. I've not seen that for a while. JAMES AITKEN: It was brutal. It was just this mad scramble for dollars because there was this absolute preference for cash, dollar cash. You know the world's in a bit of a bad spot when you can't even sell a Tbill, or the bid offer spread on a T-bill is like 10 basis points wide, which it was. That's just insane. That added to the panic when corporate treasuries around the world said, oh, I'm just going to just move out of my T-bills into dollar cash. It's like, you mean it's 10 basis point wide, and I'm actually hitting a negative. It was bizarre. Let's use a real anecdote here to help illustrate the point. Yes, there's been a tremendous amount of dollar borrowing around the world over the past several years. No surprise, because large scale asset purchases in the United States in particular, reduce the flow of dollar securities. We know that. I was in Beijing and Shanghai in February 2017. It was extraordinary, very humbling experience, by the way, because you realize you just know nothing about China at all. You can read everything you like, but it's just unknowable, almost, almost. I met some of the treasurers of the big Chinese policy banks. It was a fascinating discussion about how they manage liquidity. There's the onshore Renminbi liquidity, which within reason, within political reason, can be managed to increase yield. Then there's the gigantic dollar liquidity buffers that the biggest Chinese banks have offshore. That's when I suddenly realized wait a minute, who owns all the dollar paper issued by Chinese corporations? Where is the bulk of it? The answer is tucked away in the Treasury books of the biggest Chinese banks. Now, of course, there's a smattering of other dollar paper that falls into the hands of sophisticated mutual funds, the Evergrande, probably a dreadful example but Evergrande paper and other paper, there's some mutual fund holds, or mutual funds plural hold, but again, the key point here is that a lot of this dollar paper issued by wobbly Chinese corporates is tucked away in the dollar balance sheets of the big Chinese banks. I would suggest that they're very interested in continuing to support the home team. I imagine it's extremely unlikely that they're a forced seller. If things got immensely grim in China, I would imagine that the People's Bank would happily lend against dollar paper issued by the most critical Chinese borrowers. Why have I shared all that with you? Look, I've been as worried as the next person for a long time about the minimum amount of dollars, if one thinks about it that way, that the Chinese financial system may require on any given day to remain on an even keel. There's one little magic trick that I think people may have overlooked after August 2015, yes, there was a lot of styles of Renminbi for dollars from August 2015 onwards, but the magic trick is that those dollars did not leave the Chinese financial system. They were redeposited with the Chinese banks. That's one of the ironies of that episode. The point I'm making here is like yes, am I watching the price and the yield on Evergrande bonds in particular? Absolutely. Absolutely. Am I watching the cost of dollar high yield bond spreads from-- Asia high yield dollar bond spreads? Absolutely. If you asked me to rank the issues that worry me now, I put that it might be in the top 10 maybe, but it's not there yet. I think the broad answer to your question about how hard is it to downstream dollars to the people that need them in emerging markets, I would say it's improving. It was remarkable to see yesterday that the Bank of Indonesia announced they too have created a dedicated $60 billion repo facility with the New York Fed. That's remarkable. Now, I can't tell you with any certainty what difference that makes to the Indonesian financial system and Indonesian dollar borrowers, but the fact that Indonesia has that backstop, I would suspect it does a lot of confidence across the Indonesian corporate sector. Really, I don't think we've answered, ultimately answered your question about how do we ensure there's always adequate dollars flowing around but there are a few things being worked on particularly in the IMF to create backstops, which might give everyone time to think and reflect.