If the demand shock and pricking of the corporate debt bubble following coronavirus-inspired lockdowns were not enough for the world to bear, we now have a new crisis in our midst -- the short dollar crisis.
Its contagious impact on the rest of the world has been felt over the last two days and it is the main reason why asset classes continue to be liquidated and collapse despite global central banks' valiant efforts and the Federal Reserve exhausting its entire 2008 crisis playbook.
China was the first region to face the coronavirus epidemic and tackled it head on, taking draconian measures to contain the disease before it spread rapidly. It has been 50 days since these measures were taken, and now some semblance of normal life is returning in China. However, after tackling the infectious pathogen, it finds itself in a world that is binging not just on toilet paper rolls, but also on dollars, which is taking Asia down another leg. What is going on?
Debt was always going to be our nemesis, especially following all the money that was printed to keep the system afloat after the global financial crisis in 2008. The system became addicted to it and knew no other way to survive without it. That is why the Fed kept lowering rates and printing more dollars, so that it could support the equity markets and all the corporate debt that was associated with it as new dollars were used to pay back old dollars.
The vicious cycle continued. As companies did not grow or produce more, this illusion of cash assisted them in buying back their stock, showing shareholders how "accretive" it was. Today, as the top line shuts down, they have no buffer and no cash. And yet they want the Fed to bail them out after paying themselves handsomely as the equity markets moved higher. In order to cover their costs, they are drawing on all their credit lines from banks and whatever instruments in place to call that cash up front, a dollar demand surge.
Now that is just the U.S. Let's talk about Europe and Asia/Emerging Markets. These countries are inundated with dollar debt. According to the International Monetary Fund (IMF), 61.7% of the world's central bank reserves were held in U.S. dollars at year-end 2018 as more than half of commerce is denominated in dollars.
Given the dollar's role as the reserve currency, it is understandable that U.S. central bank policy affects all countries beyond its borders. Looking back at all emerging market crises, they have commenced as the Fed embarked on a tightening monetary policy path.
Mexico fell victim in the 1994 tightening cycle when the Fed raised rates 3% to 6%, causing a devaluation in 1995. Following the "tequila crisis" the Fed kept rates steady until raising them in 1997, which caused a collapse in Thailand; it had to devalue its currency, setting off the Asian currency crisis that hurt Indonesia, South Korea and Malaysia and caused Russia to default on its debt a year later. In 2000, when the Fed again tried to raise rates, it popped the dotcom bubble and Turkey and Argentina went into downward spiral.
If one notices, there is never any crisis during times when the Federal Reserve is in accommodation or easing mode. Prior to the coronavirus outbreak, there were signs of a dollar shortage in emerging markets as debts were due but there was not enough revenue to pay them off as these countries have over-borrowed and under-produced. Turkey's currency collapsed, Lebanon was running out of dollars since last year, and Argentina was restructuring its debt.
Total world debt sat closer to $253 trillion by September 2019, boosted mainly by higher government borrowing and non-financial corporates. It is no surprise that Chinese debt has been picking up aggressively over the years, China's household and general government debt are now at all-time highs of 55% of GDP. Total Chinese debt is closer to 310% of GDP, one of the highest in emerging markets.
The entire financial system is built on a very delicate mix of leveraging one instrument to buy another and then another. It is similar to the mortgage crisis in 2008, when banks packaged combinations of good and bad loans as one instrument that showed "better" returns. It was still made up of a mix of toxic products. When one goes sour, the entire chain goes sour, and therein the house comes crashing down.
Given the moves in high yield, investment grade, corporate and sovereign credit across the board due to liquidation, coronavirus lockdowns and a lack of reserves to support it all, the debt that is priced in dollars becomes even higher as local currencies tank because they need to buy more dollars to pay the same debt-servicing bills.
One can argue that the Fed is lowering rates, not raising them, but the other central banks also are cutting rates and printing their local currencies, too. The U.S. dollar is still holding up relatively better and hence other countries' debt-servicing costs are skyrocketing.
Today we have a host of non-financial corporates, banks, and now sovereigns running into the system to soak up as much dollars as they can find just to meet their obligations. The U.S. central bank is the default lender to entire world and now to all the companies, too. That's why this crisis is getting bigger than even 2008.
Two days ago as the market opened, we saw sterling drop 450 basis points versus the dollar and the euro fall 250 basis points against the dollar in just one day. The Australian dollar versus the U.S. dollar fell 10% (1,000 basis points) in two days.
In a world where foreign exchange moves usually are limited to plus or minus 0.1% in one day at the most, the current action is screaming distress. And we are talking developed market currencies, not emerging market currencies that are even more volatile and less trustworthy. The Kiwi dollar is back down to 2009 lows, the Aussie dollar vs. the yuan is back to 1993 lows, and Asia-Pacific foreign exchange is the lowest it has been since 2004.
This market is yelling for help across the board, whether it is yen/dollar or euro/dollar; no matter how much U.S. dollars the Fed is printing, there is still a shortage for a world that is inundated with dollar debt.
The FRA/OIS spread is a spread that tracks the difference between the federal funds rate and three-month Libor (interbank lending) rate, in the case of the U.S. It is a measure of how much stress is building in the system, and this spread has been blowing out recently, suggesting that banks are unable to or cannot lend.
Despite the Fed's bazooka $4.5 trillion repo operations and $700 billion of quantitative easing plus its emergency rate cut of 150 basis points, this spread shows no signs of easing. The U.S. corporates could be taken care of as the Fed released facilities, but emerging markets have seen record outflows in billions lately as they scramble to find even more dollars. This is why all asset classes are being liquidated as the need for cash hits everything, no matter the quality or value.
What is the solution? We are certainly in unchartered territory, but one thing is certain: The U.S. will need to print heaps and heaps of more dollars to flood the market enough that the dollar starts falling, not rising. But how can it do so without actually defaulting itself?
One historical precedent is 1985, when five central banks gathered in New York's Plaza Hotel and coined the Plaza Accord, whereby these central banks got together and sold the dollar aggressively all the way until 1987. Perhaps that is the answer; only time will tell. But one thing is clear: As much as the U.S. enjoys its imperial role as the world's reserve currency, it also must bear the burden of making sure the world does not default.
The lion can only rule if there is someone left to rule.
