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The Global Dollar Short Squeeze

The_Global_Dollar_Short_Squeeze_(Image)[1]

There is currently a short squeeze affecting most of the global economy, slowing its growth. This has been the case well before the impacts from the trade war and the coronavirus.

A short squeeze occurs when something that is heavily shorted goes on to rise sharply in price for one reason or another. That rise in price forces many short-sellers to cover their shorts, meaning they have to buy the security and thus unintentionally help push the price up further, which can force even more ardent short-sellers to buy-to-cover their positions as well. Traders that see the short squeeze occurring can also buy into it, further exacerbating the price increase. This creates a vicious cycle of more and more buying pressure until the imbalance is finally unwound after buyer exhaustion.

Short squeezes are more common with smaller companies, with dollar amounts that are not very large even though the percent increase can be quite substantial. Every once in a while, though, a giant short squeeze occurs. For example, Volkswagen’s short squeeze that happened more than a decade ago was huge.

Volkswagon_Short_Squeeze_Chart_(Image)[2]

Volkswagen briefly became the world’s most valuable company during the global financial crisis due to a short squeeze. As one of the largest automakers in the world, Volkswagen encountered challenges during the recession, and was heavily shorted. Porsche then began to buy a larger stake in Volkswagen, which caused shorts to cover the positions, which then triggered a vicious cycle, temporarily resulting in a stock price bubble.

However, a short squeeze of even that size is tiny compared to what is occurring now, without hyperbole. We’re currently in arguably the largest short squeeze in history; something measured in trillions rather than billions, and lasting for years now.

This one, though, is not about a single stock. It’s about a currency, and it affects most of the global economy including the United States.

The Global Dollar Short Squeeze

The strength or weakness of the U.S. dollar is very important for global growth, including S&P 500 earnings growth. A stronger dollar generally impedes growth, while a weaker dollar boosts it.

The dollar is the primary global reserve currency- the international medium of exchange and significant store of value for most major countries, even though most of them use their own currencies domestically. The dollar’s claim to fame is that almost all oil is priced in dollars, globally. If France buys oil from Saudi Arabia, for example, they don’t pay in either of their own currencies; they pay in dollars. The same holds true for many other commodities.

The risky part of this system is that many foreign governments and corporations borrow in dollars, even though most of their revenue is in their local currencies. The lender of those dollars is often not even a U.S. institution; foreign lenders often lend to foreign borrowers in dollars.

This creates currency risk for the borrower, a mismatch between their revenue currency and their debt currency. They do this because the borrower can get lower interest rates by borrowing in dollars rather than their local currency, thus taking on currency risk themselves instead of the lender taking on that risk. Sometimes, dollar-denominated bonds and loans are the only option for them.

By doing this, the borrower is basically shorting the dollar, whether they want to or not. If the dollar strengthens, they get hurt, because their debts rise relative to their local-currency income. If the dollar weakens, they get a partial debt jubilee, because their debts fall relative to their local-currency income.

There are a lot of variables that can affect currency strength. Current account balances are generally the_foundation_for_currency_strength[3] over the long run, but interest rates and supply/demand imbalances affect it strongly during short and intermediate time periods.

For the dollar specifically as the global reserve currency, there is an extra variable due to all of this external debt. Ironically, the more dollar-denominated debt there is in the world, the more demand there is for dollars, because those borrowers need dollars to service their dollar-denominated debts. That can push up the value of the dollar and further hurt dollar borrowers. It can have short squeeze characteristics, in other words.

Nations, especially emerging markets, try to offset this dollar short risk by holding foreign-exchange reserves, primarily in the form of dollars. That way, they have both liabilities and assets denominated in dollars, so that their dollar-denominated assets can be used to support their dollar-denominated liabilities if need be. Historically, central banks tend to accumulate dollar-denominated treasuries during weak-dollar periods, and hold them steady or sell them to defend their currency when the dollar is strong.

Under the current global monetary system that came into effect in 1971, the dollar has had three major cycles of weakness and strength, and each one of these cycles of strength has caused a global short squeeze, leading to financial crises, and impeding growth until resolved. Nations that have the least foreign-exchange reserves and/or the most liability exposure to the dollar break first during a strengthening cycle, while nations that have the most reserves or the least dollar liability exposure manage to get through the turmoil comfortably intact.

Trade_Weighted_Dollar_Index_(Image)[4]

Chart Source: St. Louis Fed

Of course, all currencies have weakened vs hard assets over time, including the dollar. In this context, a “strong dollar” and “weak dollar” are in reference to a basket of foreign currencies.

1980’s Dollar Spike

The first and largest dollar spike occurred in the mid-1980’s. From the 1970’s and into the early 1980’s, the U.S. dollar encountered serious devaluation and inflation, so Fed Chairman Paul Volcker hiked interest rates up to the double digits to stabilize the dollar and force inflation back down. This, however, made the real interest rate on the dollar quite high, and thus made it quite strong into the 1980’s. The Plaza_Accord[5] between multiple nations, including the United States, was required to intentionally devalue the dollar.

The reason that the Fed was able to raise interest rates so sharply, and for the dollar to get so strong, was that there was less debt in the global system, and especially in the U.S. system, relative to GDP. The U.S. government and U.S. companies could handle higher interest rates on their debt, because their overall debt levels were low relative to their income levels. In addition, global trade as a percentage of global GDP was less than 40%, compared to 50% a couple decades later, and up to 60% recently. So, in addition to being way less indebted, countries were a significantly less interconnected.

Global_Trade_as_a_Percentage_of_Global_G_(Image)[6]

Chart Source: World_Bank[7]

Emerging markets as we currently know them didn’t exist during the 1980’s dollar spike. The MSCI Emerging Market Index was created shortly afterward in 1987, and it was a small share of global GDP at the time. Developing countries of course existed during this dollar spike, but just weren’t significant players in the dollar market. So, this 1980’s dollar spike was mostly an issue between developed markets: the United States, several European nations, and Japan.

1990’s-2000’s Dollar Spike

During the 1990’s, several emerging markets began to grow substantially, and began taking on dollar-denominated debt while the dollar was comparatively weak.

Meanwhile, the United States enjoyed prosperity from the Baby Boomer demographic bulge in prime working age combined with the dotcom boom and its associated new mega-cap technology companies. A rare U.S. government budget surplus began to occur, and the dollar experienced its second spike to strength.

By the late 1990’s, this strengthening dollar damaged many emerging market currencies, contributing to the Asian_Financial_Crisis[8] and the collapse of Long Term Capital Management. Thailand, South Korea, Russia, Malaysia, and other emerging markets experienced major currency problems. In general, they had high dollar-denominated debts and little foreign-exchange reserves to support those debts, so when the dollar strengthened, their effective short positions on the dollar (by borrowing in dollars but receiving income in local currencies) received a metaphorical margin call. Currency pegs broke, tears were shed, and the IMF performed multiple bailouts to help stabilize the crisis.

As the dotcom bubble eventually unwound, the U.S. dollar weakened substantially, and the 2000’s became a new boom time for emerging markets. Many of them enjoyed massive outperformance over the next several years, and the “BRIC” acronym became popular to describe where the future would supposedly be.

Emerging_Markets_2000s_Boom_(Image)[9]

2015-Present Dollar Spike

The past two decades have seen the rise of emerging markets, especially centered around China.

Today, emerging markets represent a substantial chunk of total global GDP and based on population and productivity trends, many sources, rightly or wrongly, expect them to keep growing their share.

Emerging_Markets_Growth_Projections_(Image)[10]

Chart Source: PwC_Global[11]

The U.S. housing and banking system was the epicenter of the global financial crisis in 2008, and the Fed used a few rounds of quantitative easing (i.e. expanding the monetary base to buy U.S. government debt and other securities) in the aftermath, which kept its currency relatively weak due to plentiful supply.

When the United States finished its third round of QE in late 2014 and shifted to tighter monetary policy, however, the dollar shot up and has remained elevated, in what has become the third dollar spike of modern financial history. A combination of looser fiscal policy and tighter monetary policy than the rest of the developed world from late 2014 to the present has been a recipe for a strong dollar, while it lasts.

In 2018, the strong dollar broke Argentina and Turkey’s currencies and drove the countries into recession, which is similar to what happened to several emerging markets in the late 1990’s. Argentina and Turkey had (and have) a large amount of dollar-denominated debt relative to their GDP, and low foreign-exchange reserves. Argentina’s dollar debts are mainly sovereign (Argentina’s government), while Turkey’s dollar debts are mainly with Turkish corporations.

The countries that were at the epicenter of the late-1990’s emerging market currency crisis, on the other hand, have been solid this time around. This includes Thailand, South Korea, Malaysia, Russia, and so forth. They learned their lesson from the second dollar spike in the 1990’s and built up huge foreign-exchange reserves afterward, which has served like armor to keep them relatively steady during this third dollar spike. The Thai baht, in particular, has strengthened compared to the dollar over the past 15-20 years. Thailand has huge foreign-exchange reserves and a positive current account balance.

Emerging market investors continue to pay sharp attention to Argentina and Turkey, while also being on the look out for Chile, Indonesia, Mexico, and others as it relates to managing their relatively high amounts of dollar liability exposure.

Why Each Time is Worse

Each of these three dollar spikes over the past five decades caused harm to the global financial system at a lower level of dollar strength than the previous spike, resulting in either a planned correction or a self-correction towards a weaker dollar. There are likely two main reasons for this.

Firstly, global trade accounted for a larger and larger share of global GDP in each of the three spikes (the first one less than 40%, the second one around 50%, and the third one around 60%, as previously mentioned). Secondly and perhaps more importantly, U.S. and foreign markets have had increasingly high debt-to-GDP ratios over the decades. With more leverage in the system, and with more connectivity between economies, it takes smaller currency fluctuations for something to break.

Based on BIS data, in 2000 during the second dollar spike, non-bank government and commercial borrowers outside of the United States had a little over $2.3 trillion in dollar-denominated debts. By way of comparison, U.S. GDP was $10.1 trillion, and U.S. broad money supply was $4.6 trillion. So, ex-USA dollar-denominated debts were 23% of U.S. GDP, and 50% of U.S. broad money supply. This is workable.

As of the most recent data from Q3 2019, there are now almost $12.1 trillion in dollar-denominated debts among non-bank government and commercial borrows outside of the United States. This is up to 56% of U.S. GDP, and 78% of U.S. broad money supply. There simply aren’t enough dollars in the global system currently for this to work out comfortably.

Here is the BIS graph for dollar-denominated debt outside of the United States (pink and blue areas). The left side shows total debts, while the right side shows emerging market debts:

BIS_Dollar-Denominated_Debt_(Image)[12]

Chart Source: BIS_Global_Liquidity_Indicators[13]

And here is a chart, using BIS data and various central bank data, showing the dollar-denominated debts and foreign exchange reserves, as a percentage of GDP, for select emerging market countries:

Emerging_Market_Dollar-Denominated_Debts_(Image)[14]

Data Source: BIS, Trading Economics, various central banks

This large amount of foreign dollar-denominated debt means there is a ton of demand for dollars, out of necessity to service that debt. This constant bid for dollars acts a short-squeeze, driving up the value of the dollar, which puts more pressure on these countries with high dollar-denominated debt, exacerbating the short squeeze. It’s not an exaggeration to say it’s likely the biggest short squeeze in history, similar and larger than the two previous dollar spikes.

The strong dollar, combined with how much dollar-denominated debt that currently exists in the world, constrains both U.S. and foreign economic growth at current levels. It’s a multi-trillion-dollar short squeeze, even though it’s less visually dramatic compared to something like the Volkswagon short squeeze.

Self-Inflicted Wound

For this third dollar spike, the United States has arguably been hurt by its own strong currency more than the past two times, but most of the damage is under the surface so far.

During the previous two dollar spikes, the United States had less vulnerability to a strong dollar, and other nations were less armored against it. In the 1980’s, the dollar got so strong that it required a planned international agreement to weaken it. In the 1990’s, several emerging market nations broke first, and the United States was only modestly impacted.

This time, however, the United States has more vulnerability to the negative effects of its own strong dollar, and the majority of emerging market nations have better foreign-exchange reserves to defend themselves against it.

In recent decades, the S&P 500 now receives over 40% of its revenue from international sources, and a stronger dollar means that when those foreign revenues are translated back into dollars, it comes out to a lower number of dollars. The percentage of S&P 500 sales from foreign sources peaked in 2014 and has been on a mild downtrend, coinciding with when the dollar became strong in late 2014 (which mainly negatively affected sales for 2015 and after).

S&P_500_Foreign_Revenue_(Image)[15]

Table Source: S&P_Global_Indices[16]

Total U.S. corporate income has been almost completely flat for the past several years, and peaked back in 2014. Once the dollar became strong in late 2014, corporate profits entered a 5+ year flat period and counting:

Corporate_Profits_vs_Strong_Dollar_(Image)[17]

Chart Source: St. Louis Fed

You can see on the chart that it was similar during other dollar spikes from 1983-1987 and 1996-2003; dollar spikes are historically bad for U.S. corporate profit growth and this third one is no different.

This latest bout of corporate stagnation has been somewhat masked by higher equity valuations, corporate tax cuts that boosted after-tax profits, and large companies buying back a lot of their shares each year to increase-per share earnings despite the fact that raw company-wide operating income isn’t changing much for many of them.

While the strong dollar gives U.S. consumers more buying/importing power, it makes U.S. products and services more expensive, and thus less competitive in the export market. Basically, it helps some groups live above their means (and U.S. asset prices have been doing great), but it hollows out the U.S. manufacturing sector and negatively affects the blue collar workforce the most.

Plus, the United States currently has a higher government debt-to-GDP ratio than any time in post-WW2 history, including far higher than the previous two dollar spikes. During the 1985 dollar peak, the U.S. had about 40% debt-to-GDP. During the 2002 dollar peak, the U.S. had about 55% debt-to-GDP. In 2020, the U.S. has over 105% debt-to-GDP.

This chart shows just the portion held by the public:

Treasury_Bond_Government_Debt_(Image)[18]

Chart Source: Congressional_Budget_Office[19]

And it continues to grow; the United States is running large deficits (5% of GDP) during a period of low unemployment for the first time since the Vietnam War. In other words, we now have significant structural government budget deficits rather than just temporary cyclical/recession deficits:

United_States_Deficits,_Structural_Chang_(Image)[20]

Chart Source: Goldman Sachs, Retrieved from CNBC

Unlike most developed countries, the United States government is heavily reliant on foreigners lending it money by buying its Treasuries. Foreigners currently hold $6.7 trillion in U.S. government debt.

However, from the start of 2015, due in part to the strong dollar environment, foreigners have been buying very little U.S. government debt compared to what they used to, which means that domestic sources have had to buy most of it instead. The U.S. government increased its debt levels by $4.6 trillion from 2015 through 2019, but foreigners only bought $700 billion of that, and almost all of that was private investors during a brief period in the first 2/3rds of 2019.

Foreign central banks mainly accumulate foreign-exchange reserves (i.e. buy Treasury notes and bonds) during weak dollar environments, not strong dollar environments like we’re in now. During a strong dollar environment, they rely on their Treasury reserves to protect their currency and service their dollar-denominated debts if need be. Think of it like a squirrel collecting nuts in the summer to consume during the winter. Squirrels don’t collect nuts in the winter, and foreign central banks don’t buy Treasuries when the dollar is strong and strengthening

This chart shows the percentage of total U.S. debt held by foreign holders over time, which currently stands at around 30%:

Percent_Debt_Held_by_Foreigners_(Image)[21]

Chart Source: St. Louis

In other words, while there is significant foreign demand for dollars (especially to service the aforementioned dollar-denominated debts), there is not a big foreign demand for Treasuries. That’s a key distinction, and that’s what generally happens when the dollar is strong. When the dollar starts rising into a spike, foreigners hold less and less of the debt, as marked in the chart above. This has happened in all three dollar spikes. However, it matters more this time because U.S. federal debt as a percentage of GDP is far larger than it used to be, the U.S. has been more reliant on foreign funding in recent decades.

Large U.S. government debt and deficits, combined with a relative lack of foreigners buying those Treasuries for the past five years, eventually contributed to the September 2019 spike in overnight lending rates (the “repo spike”, where interest rates shot up dramatically until the Federal Reserve intervened).

Image[22]

Chart Source: Trading_Economics[23]

With $4.6 trillion in new U.S. treasuries issued from Q1 2015 to Q3 2019, and about $3.9 trillion of that funded domestically, it means that about $3.9 trillion in dollars were sucked out of the U.S. financial system and converted into Treasuries over a five year period. That’s a big dollar liquidity drain.

Foreign holdings of U.S. treasuries peaked in August 2019 and turned down, just weeks before the repo spike that occurred in mid-September. Leading up to the repo spike, U.S. domestic balance sheets were stuffed full of Treasuries (especially T-bills) and couldn’t buy much more, resulting in a dollar liquidity shortage and an excessive supply of Treasuries. Large banks (primary dealers of Treasuries, the ones who serve as middlemen) ran into post-crisis lows for cash as a percent of total assets (blue line below) during the week of the repo spike:

Bank_Dollar_Shortage_in_September_2019_(Image)[24]

Chart Source: St. Louis Fed

Within a day of the liquidity shortage and repo spike, the U.S. Federal Reserve stepped in to begin expanding the monetary base to borrow and buy some of the excess supply of Treasuries. The Fed has been the main buyer of U.S. Treasuries since that time. So, rather than sucking existing dollars out of the system as they were from 2015-2019, newly-issued Treasuries are now being funded by newly-created dollars, which means less or no liquidity drain.

Federal_Reserve_UST_Buying_(Image)[25]

Chart Source: St. Louis Fed

In other words, after Argentina and Turkey, the United States is ironically the country that “broke” next in this strong dollar environment, and began monetizing its government debt due to an acute dollar shortage. Fortunately for the United States, it can print its own dollar-denominated liabilities, so its break is less spectacular and more manageable than countries with dollar liabilities that can’t print dollars.

The Triffin Dilemma Unfolds

In the 1960’s, economist Robert Triffin noted that global reserve currencies have to run large persistent trade_deficits[26], which has been coined the Triffin Dilemma. If the reserve country doesn’t supply the world with a lot of their currency, then the world simply can’t use that currency for international trade, commodity purchases, or as a store of value.

So, the U.S. imports goods and commodities, exports less of those things, and exports a lot of dollars to fill the difference. Foreigners have historically then reinvested many of those dollars into buying U.S. government debt, including foreign central banks that use those Treasuries as foreign-exchange reserves, as previously discussed.

This persistent trade deficit can last a long time, but not forever, meaning that global reserve currency status is inherently temporary, even if very long-lasting. The global reserve country benefits from the privilege for a long time, but eventually is harmed by it.

U.S._Trade_Deficit_(Image)[27]

Chart Source: St. Louis Fed

These trade deficits are self-reinforcing rather than planned. It’s not like the global reserve country necessarily decides to have persistent trade deficits. Using the United States as an example, if the whole world agrees or is forced to mainly use dollars to buy commodities and settle the majority of international deals, then there is naturally a high demand for dollars relative to its supply, and thus it has a permanent “extra” source of strength compared to what it should have based on its normal variables alone. This currency strength makes U.S. exports less competitive and gives us more import power, which leads to persistent trade deficits and causes us to export a bunch of dollars as the difference. The U.S. currency rarely or never gets a chance to weaken enough to resolve the trade deficit.

The world is now outgrowing the dollar in terms of scale, but still uses the dollar as the global currency. The network effect (and U.S. military force) makes it very hard to shift away to a new system. The United States was 20% of global PPP GDP back in 2000, but only 15% of global PPP GDP today, according to the World Bank. The world’s biggest consumer of commodities during the past decade has been China, not the United States.

Imagine, as an extreme example, that the entire world had to use Swiss francs for its international transactions and commodity purchases. It simply wouldn’t work, because there isn’t enough money supply from that small country for the whole world to use. It’s not liquid enough; there aren’t enough francs.

The current system is running into that issue, where the United States, as large as it is, is a diminishing share of global GDP, global money supply, and global commodity demand. But, the world is still constrained by dollars, so there are growing pains. The dollar likely does not currently have enough liquidity to serve as the sole global reserve and commodity-pricing currency; there aren’t enough dollars.

Additionally, after decades of trade deficits and current account deficits, the U.S. net international investment position is at -50% of GDP, meaning that foreigners own far more of our assets than we own of their assets. Specifically, foreigners own $39 trillion in U.S. assets, while we own $28 trillion in foreign assets.

United_States_NIIP_(Image)[28]

Chart Source: U.S._BEA[29]

How Does The Third Dollar Spike End?

Some analysts believe that the dollar will continue to strengthen until it wrecks the whole global financial system, requiring an international accord to weaken it.

As far as I can tell, while this outcome is plausible, this viewpoint underestimates the weakness that the United States has for the strength of its own currency, how acute the dollar shortage within the United States has become, how much reserves and U.S. assets foreigners own, and how aggressive the monetary response from the Federal Reserve could be in the next couple years as they shift from tight to loose monetary policy.

The United States has a large trade deficit, significant current account deficit, major fiscal deficit, and a deeply negative international investment position; its currency would likely be lower than where it is now if not for the persistent international demand for dollars to service the large amount of dollar-denominated debts. Once there is a sufficient supply of dollars for those debts, the dollar’s natural direction is likely down, just like how it resolved after the previous two dollar spikes.

Based on the numbers, my view is that this third dollar spike likely ends when the Federal Reserve expands its monetary base by trillions of dollars to fund U.S. government deficits over the next several years, for lack of sufficient foreign and private buying of that debt. If performed at sufficient scale, this would loosen the global dollar liquidity shortage. There are a few different paths and timelines that could occur between now and then, and it’s a process more-so than an event. Central banks can also perform currency swaps or other agreements as needed, if they coordinate.

The federal debt of the United States is increasing by over $1 trillion per year, and this deficit will likely grow up to $1.5 trillion or perhaps over $2 trillion annually if the U.S. encounters a recession, depending on the severity. Any amount of this new debt that is not purchased by foreign and private investors would need to be monetized by the Federal Reserve, meaning a greater supply of dollars.

To summarize the scale of the global ex-USA dollar network, foreigners own $39 trillion in U.S. assets and have $12 trillion in dollar-denominated debts, although the asset-holders and debtors are often not the same regions (e.g. Switzerland is a big asset holder with a surplus, and Turkey is a big debtor with a shortage). Meanwhile, the U.S. is running annual fiscal deficits of well over $1 trillion, and is exporting about $600 billion in dollars annually via its trade deficit, or $3 trillion gross from the U.S. import figures alone.

With the scale conceptualized, let’s summarize the timeline. For five years from late 2014 to late 2019, the United States ran tight monetary policy and loose fiscal policy. Tight monetary policy meant that they were holding the balance sheet flat, and even shrinking it briefly, while also maintaining higher interest rates than most other advanced countries. Loose fiscal policy meant that they were running large government deficits, which act as an economic stimulus. This combination of tight monetary policy with loose fiscal policy is a recipe for a strong currency, while it lasts.

Europe has been doing the opposite for these past 5 years, with nearly balanced sovereign budgets in aggregate (largely thanks to Germany) but large quantitative easing programs that have been substantially expanding the Eurozone monetary base. In other words, they had tighter fiscal policy than the United States, and looser monetary policy. This is a recipe for a weak currency.

However, the tight monetary policy of the United States “broke” in September with the repo spike, and the Federal Reserve ended its 5-year tightening policy and began increasing its balance sheet. From that late September timeframe, I initiated_my_structural_bearish_view_on_the_dollar[30], suggesting that we were now likely in a topping process. The United States now has loose fiscal policy and loose monetary policy.

I didn’t rule out the possibility of one more leg of the dollar spike upward, and I continue to hold some short-term treasuries as a defense for that scenario. For the long run, I staked out a position for a weakening greenback. With my relatively low-turnover investment strategy, I prefer positioning mainly for the long-term outcome of a given scenario rather than various intermediate routes to get there, as I would if I were a trader.

We always need to update our position as new information comes in, though, so let’s check on the status of that view. How has the dollar changed since the repo spike?

The DXY dollar index (which is heavily weighted by the euro and yen) did indeed quickly fall from late September through December, but has since swiftly rebounded back to a slightly higher level due to recent weakness in the euro and yen:

Dollar_Index_Bloomberg_(Image)[31]

Chart Source: Bloomberg

On the other hand, the much broader trade-weighted dollar index has been in a bearish trend from its September/October peak, with a series of lower highs and lower lows, but also with a solid bounce starting in January:

Trade-Weighted_Dollar_Pivot_(Image)[32]

Chart Source: St. Louis Fed

And the dollar, like all other currencies, has recently fallen vs a neutral central bank store of value like gold. Gold recently broke out to multi-year highs in dollar terms:

Gold_Post_Repo_Spike_(Image)[33]

Chart Source: Kitco & TradingView

From September through December 2019, the Federal Reserve was rapidly expanding its balance sheet with a combination of repo lending and outright T-bill purchases. In December, they front-ran the liquidity shortage by providing extra liquidity to ensure that there was no acute liquidity shortage during the year-end week. The dollar dropped pretty fast over this period.

From the beginning of January 2020 to the present, however, the Fed has continued to buy T-bills but has reduced its repo lending, so the Fed’s balance sheet has been in a sideways pattern rather than a growing pattern. This shift to a sideways pattern in early January coincided with a bottom in the various dollar indices, and the dollar has rallied sharply since then. In other words, the Federal Reserve has briefly re-tightened, and that tightening effect, all else being equal, is strong for the dollar.

Balance_Sheet_Pivot_(Image)[34]

Chart Source: St. Louis Fed

If we break down the various components of the Fed’s balance sheet expansion since the September repo spike, we can see that their T-bill purchases continue upward unfazed (red), their holdings of mortgage-backed securities (green) continue to be wound down (normalized), and repo lending (purple) hit a peak on January 1 and receded, resulting in the overall balance sheet temporarily going flat since January (blue):

Balance_Sheet_from_Repo_Spike_(Image)[35]

Chart Source: St. Louis Fed

However, bank cash levels as a percentage of assets remain at post-crisis lows. The Fed’s repo operations, which were under-subscribed through December, now have had several days lately of daily oversubscribes, meaning that repo demand is outpacing what the Fed is willing to give. Liquidity is tight again.

Unless foreigners start buying more U.S. Treasuries again (their holdings peaked back in August 2019 according to the latest data), it looks like the Fed will need to continue to monetize growing U.S. government deficits in 2020 and beyond, meaning that even as repo lending subsides, the Fed’s balance sheet should resume an upward trend within Q2 2020 thanks to cumulative T-bill purchases, regardless of whether or not they wind down their repo lending program.

For now, however, as long as the balance sheet remains in a sideways pattern, the dollar is likely to remain fairly strong. There simply won’t be enough dollars to fund the world’s dollar needs. When the Fed’s balance sheet starts a sustained multi-month increase again, meaning that dollar supply becomes more abundant, the dollar has another sizable chance to weaken.

Five years of relatively tight monetary policy from 2015-2019, with Treasury issuance sucking dollars out of the financial system, has kept the dollar strong, and it can still have spikes of strength whenever the Fed stops expanding its balance sheet or if there is a sharp flight-to-safety trade. A portfolio must be able to handle those spikes. However, from late 2019-onward, the Fed’s expansion of the monetary base will likely be a key financier of treasury issuance, which should eventually weaken the dollar and relieve the global liquidity shortage.

My base case continues to be for a weaker dollar over the next several years, with the possibility of a brief dollar spike during the process. In other words, the purple line is my higher-probability setup, while the orange line is the alternative:

Dollar_Spike_Directions_(Image)[36]

Chart Source: St. Louis Fed

The orange line could occur if a lot of private European and Japanese investors buy un-hedged Treasuries in a risk-off move, which would delay the need for increased U.S. debt monetization by the Federal Reserve. Either way, I expect down for the dollar in the multi-year long run, but the path to get there has these two main outcomes, in my view.

The key metric to watch for timing, or for the risk of a dollar spike, is the direction of the Federal Reserve’s balance sheet (and upstream from that: Japanese and European un-hedged private buyers of Treasuries). If domestic and/or foreign sources aggressively buy more Treasuries, they can push back the timeline for the Fed’s continued monetization of U.S. deficits. On the other hand, as global demand for Treasuries becomes insufficient to cover $1 trillion+ in annual U.S. government deficits and growing, the Fed will be on the hook to make up that difference by substantially expanding the U.S. monetary base, supplying a ton of dollar liquidity for years.

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Stay up to date by joining the free_newsletter[37]. It comes out every 6 weeks and provides updates for the business cycle, various investment ideas, and a look at my own portfolios.

If you’re interested in this topic, also check out the series of currency articles I’ve written lately, which discuss various historical case studies:

* The_Subtle_Risks_of_Treasury_Bonds[38]

* How_to_Win_a_Currency_War[39]

* Why_Trade_Deficits_Matter[40]