Good Morning… Risk off yesterday and risk on today as China trade data beats forecasts and we seem to be edging closer to peak virus. But I am still of the opinion that this equity bounce is euphoric and possibly misplaced as the economic impact is still taking shape. We are at the end of the beginning and not the beginning of the end. Make no mistake, the Fed and other central banks and governments have thrown huge amounts at this but businesses will fail and the CBs cannot save them all. Nearly 17mln Americans have lost their jobs in 3weeks for goodness sake! How can we suggest we just return to normal. The new normal may look very different with different valuations and a re-evaluation of who and what matters and consumer habits may have changed. For economies so reliant on the services sector, this is huge. The Fed actions should see the USD a lot lower but it isn’t!!! If this starts rising again and the ED front end starts falling again, then the Fed will need to do more!! I prefer the crosses at present and still see EUR underperforming against many and EURGBP still looks set to test .8500 and I would add on a rally. Earnings season start with the banks and keep an eye on those loans.

Keep the Faith..

Details 14/04/20

The Fed stimulus is huge and should weaken the USD but taking it back may create another problem: The pressure on the system and USD demand:

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There is no doubting the size and indeed the speed at which the central banks and particularly the Fed have reacted to this crisis. The numbers are simply mind-boggling but also the instruments that central banks now feel comfortable owning. When Powell became chair at the Fed, he was often quoted as taking a dim view of credit risk and blowing bubbles but now the Fed buys junk and HYG. The ECB is nothing more than a skip where you can dump junk and receive cash; any old junk. Why are they prepared to take on so much risk? That is because the system itself is close to breaking. The danger here also, is that public funds are used to bail out nefarious fund managers, speculators or irresponsible businesses. Yet last week we witnessed unprecedented moves by the Fed to buy low-rated bonds and even exchange traded funds of junk debt. Markets reacted with glee at being rescued yet again and stocks rallied; HYG rallied 7%. How on earth can they take all this back without creating another rout?

The setting of moral hazard is clear and I just wonder how damaging this may end up being. Why bother with prudence and manageable leverage when you know the Fed is there to guard against the risk? What happened to the days when companies with high levels of net debt compared with their cash flows had higher costs of funding? This relationship broke down after 2008 and never returned as the central banks removed risk premia. But some of these companies will default as the economy is no longer allowing some of these companies to hide and the Fed cannot save them all. Also, the Fed buying ETFs like LQD or HYG does nothing to help fund the economy, and merely helps the returns of investors who have already bought corporate bonds. It is a paradise for speculators and is simply wrong and a comes with a legal question mark as the obvious beneficiaries of the junk bond-buying programme are overleveraged private equity groups and unhealthy borrowers. This issue needs looking into but again, while the Fed says these moves are very short term; are they? The USD has come off but it should be lower in my view and if it rises again then the Fed will face another challenge.

Stocks rallied in Asia last night as Chinese export and import data improved and beat expectations by some margin and virus cases in many badly hit nations seem to be slowing. Risk on was back but is the S&P back up at 2800 over pricing the knock-on damage from this virus? We have seen 17mln people lose their jobs in the US alone in 3 weeks!

Just what will we see from consumer data going forwards now, which is so important to most economies now and will their appetite ever be the same again? A lot of damage has been done as we move into the US earnings data this week. Are equity investors prepared to look through what is likely to be a pretty shocking set of earnings? In Australia we saw Business confidence fall to minus 66 index points — its lowest level on record. Business conditions fell to minus 21 index points, slightly weaker than the 2008 financial crisis, although it remains above the trough seen in the Australia recession in the early 1990s but AUD rallied on the risk on theme and a broad weakness in the USD.

But the Fed has another problem and that is the plumbing that drives the global money-go-round; the Eurodollar market. This is why the Fed has extended swap lines to foreign nations (not all) and is why there is a danger that the USD demand is not going to abate. Foreign sovereigns are going to hoard dollars in a global scramble for the reserve currency. This is why the Fed went even further last week and has for a short time, reversed some of the USD strength but not much. The Eurodollar market is the plumbing in the global system and recently it sprung a leak; the Fed is here to fix it but has it done enough? Without question it has gone a long way but the numbers in the Eurodollar system are simply mind-boggling. For those new to this mechanism, a Eurodollar is an unsecured USD deposit held outside of the US. They are not under the US’ legal jurisdiction, nor are they subject to US rules and regulations. But they are the “oil” that keeps the engines of business running smoothly.

The world has dollarized everything or commoditized it. Every import, bond, loan, credit guarantee, or derivate needs to be settled in USD. This is why the EM space is so exposed to moves in the USD and a stronger USD is not what they need right now. Global financial markets and the global economy rely on the common standard of the USD for pricing, accounting, trading, and deal making. The USD is the standard; the currency of the world and the world is in demand of it. But the USD should be lower after all the Fed has done but front end EDs are near recent highs made since the Fed’s latest announcement. Keep an eye on these.

A second problem is that the flow of USD from the US to the rest of the world needs to be sufficient to meet the inbuilt demand for trade and other transactions. Yet the US is a relatively smaller slice of the global economy with each passing year. Even so, it must keep USDs flowing out or else a global Eurodollar liquidity crisis will inevitably occur; as indeed we may be experiencing.

The implications of the US becoming more insular or protectionist is immense as it will see less USDs flow out from the US as imports drop, payments made reduce while Trump works on “Making America Great Again”. That leaves a global shortage and a scramble for dollars outside of the US. The interesting thing here now will be if after all the Fed has done, which pushed me to cover a EUR short against the USD, lasts. If we continue to see stress in Libor or Eurodollar markets and the USD starts rising again from here, the Fed may have to do even more! The Fed says that it does not want to use negative rates (yet) so the short end is rather trapped; but the long end may force the curve to flatten now and the Fed and the US banks don’t want that. Maybe the next move for the Fed is YCC as we have seen in Japan; forcing the curve to remain steeper.

Having said all that, I still see stress for the EUR in all this but mainly against other currencies, especially GBP still and think EURGBP still has further to fall and .8500 is still a target. The USD is on an uncertain path here and unfortunately, COVID-19 and its huge economic damage and uncertainty, mean that global confidence has been crushed, and the Eurodollar “system” risks buckling as a result. The wild gyrations recently experienced in even major global FX crosses speak to that point, to say nothing of the swings seen in more volatile currencies such as AUD, and in EM bellwethers such as MXN and ZAR. FX basis swaps and LIBOR vs. Fed Funds (so offshore vs. onshore USD borrowing rates) say the same thing.

Unsurprisingly, the IMF are seeing a wide range of countries turning to them for emergency USD loans. It seems to me that there is still demand for the USD even after all the Fed has done. That is why Bostic and Clarida all suggest the Fed could do more.

Don’t take my word for the stresses here; this is the BIS: “…today’s crisis differs from the 2008 GFC and requires policies that reach beyond the banking sector to final users. These businesses, particularly those enmeshed in global supply chains, are in constant need of working capital, much of it in dollars. Preserving the flow of payments along these chains is essential if we are to avoid further economic meltdown. Channelling dollars to non-banks is not straightforward. Allowing non-banks to transact with the central bank is one option, but there are attendant difficulties, both in principle and in practice. Other options include policies that encourage banks to fill the void left by market-based finance, for example funding for lending schemes that extend dollars to non-banks indirectly via banks.” In other words, the BIS is making clear that somebody (i.e., the Fed) must ensure that Eurodollars are made available on massive scale, not just to foreign central banks, but right down global USD supply chains. As they note, there are many practical issues associated with doing that – and huge downsides if we do not do so. Yet they overlook that there are huge geopolitical problems linked to this step too. This is the real crisis now and not peak virus.

Can the Fed takeover the whole global financial system? Well, the issue here is that if they can’t then the whole Eurodollar exchange matrix may collapse and that means that global finance and financial markets do as well. The task ahead for the world reserve currency central bank is huge to say the least. Is the Fed prepared to push $3.4trln into saving Chinese firms for instance and what would Trump have to say about that? The US could be selective and hold an extremely powerful geopolitical tool here. Are we all reliant on the Fed now? I still do not know enough about how the Eurodollar matrix works but we all need to learn fast. The plumbing is the issue and the virus has exposed it. Essentially, we have seen nearly five years of QE1-3 in five weeks! And yet it isn’t enough. Keep an eye on the USD as a rally will signal further stress; it should be lower.

The global economic stall is a massive problem. Moreover, things are getting worse, not better and I am not talking about the virus.

One thing is abundantly clear – global trade in goods and services is going to be hit very, very hard, and that US imports are going to tumble. This is why the Fed appears to have gone all in; but has it? To my mind the Fed is not done yet as the plumbing has still got a leak. The US government will spend more, the Treasury will issue more bonds and the Fed will buy them. What a game. I thought central banks were not supposed to monetize debt. Ha; they will do whatever they have to and markets believe them it seems. I just hope they are up to the task that still lies before them; there is so much hope and for governments it is time for that choice between lives and livelihoods. For earnings we start with the banks and I will be looking at how their loans are performing but the faith in the central banks is about to be fully tested. The fact is, as millions upon millions of Americans lose their jobs in the greatest wave of unemployment in U.S. history, the Federal Reserve has decided that now is the time to spend trillions of newly created dollars in a desperate attempt to protect financial asset values. Hmm.

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Strategy:

Macro:.

Short EURGBP @ 8901.. Stop @ entry now (took substantial profits at.8760)

Short EUR@ 1.0870.. Stop above 1.0940 Closed position Thursday at 1.0895

Brought to you by Maurice Pomery, Strategic Alpha Limited.

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