USD - U.S. Treasury Doom Loop
Are Central Banks selling Treasuries to defend their currencies?
Over the past few months, market sentiment has been swinging between the acknowledgment that central banks need to increase interest rates to curb soaring inflation and the big concern that over-tightening may trigger a sharp slowdown in global growth. Both narratives have been supportive of investors’ bullishness toward the dollar. This view has been additionally fuelled by the perception that the risks of a deep recession are much higher in Europe and in Asia than in the US.
While the FED has been very aggressive in raising interest rates, monetary policy has been diverging, especially in Asia. Bank of Japan has been defying the global trend of higher interest rates by signaling that it will maintain its easing stance. China is also implementing loose fiscal and monetary policies, as they are undergoing significant macroeconomic adjustments to stabilize the economy.
The combination of diverging monetary policies and growth trajectories have been the drivers of the strong and relentless dollar appreciation. This has been particularly evident against developed market currencies and the broad Asian complex.
The yen has been one of the biggest losers, correcting 20% against the US Dollar. The GBP is now trading very close to its all-time lows and the EUR slumped over 10%, since the beginning of the year. Over the same period, the Korean Won has fallen 20%, the Chinese Yuan 11% and the Indian Rupee has dropped 10%.
These currency dynamics are becoming a game changers. The Yuan and yen are big anchors for investments and trade in Asia, and their weakness poses a big risk to financial stability. PBOC, BOJ, and the broader complex of Asian central banks are then left with no choice than stepping up their fight against the soaring US Dollar.
This has significant ramifications.
FX interventions, in fact, trigger US Treasuries selling, and in turn, wider interest rate differentials are adding to USD strengths. This feedback loop is a critical factor, which is now becoming a clear fragility.
The idea that there is a strong correlation between USD strength and selling pressure on USTs seems to be supported by the data. I found an interesting Chart by Exante, displaying the weekly changes in Foreign Central Banks' holdings of US Treasuries at the FED custody facility. UST holdings are dropping and dropping fast! We had a very significant 40bn outflow in the last week of September.
But let's take a closer look at what is going on in Asia!
The Asia-Pacific Complex
Asian nations have been digging deep into foreign-exchange reserves to mitigate the dollar’s strength. The chart below, from Bloomberg, is giving us an idea of the dimension of the dollars spent on FX interventions. This process has been quickly accelerating in recent months.
According to some estimates by Nomura, India has spent $75.1 billion this year supporting the rupee in the spot and forward markets. At the same time, China has probably spent $39.6 billion, Thailand $26.9 billion and South Korea $16.7 billion. Both the Reserve Bank of India and the Bank of Thailand have used up to 10% of their end-2021 headline reserve levels.
As the erosion of FX reserves is accelerating, Central Banks have to become creative in terms of policy actions.
What is next?
There is an interesting piece by Nomura, which summarizes some of the steps that individual Asian Central Banks may take to support their currencies. In a nutshell:
In Japan, we may see foreign asset liquidation by public pension funds and other financial institutions. China may implement the repatriation from government-related corporates, and close undesired outflow channels. India may open a forex swap window for oil marketing companies and take broader measures to slow capital outflows. Indonesia may cut in FX reserve requirement ratio, implement a tax amnesty program and prohibit foreign currencies from domestic transactions. South Korea may also look for repatriations from government-related corporates and take measures to encourage capital inflows.
What are my conclusions?
Raging US/$ strength is creating a dangerous feedback loop, where currency interventions trigger US Treasuries selling and in turn widening interest rates differentials are adding to USD strengths.
Two considerations may be important here. First, a currency crisis in Asia is a clear risk to global financial stability. And as we know, financial instability rarely remains isolated without spreading out. The second concern is related to the functioning of the US Treasury market. The US bond market is one of the most liquid markets in the world. However, adding foreign selling pressure on top of the FED hiking interest rates, while it is engaging in Quantitative Tightening, could make the treasury market volatile and dysfunctional. The UK Gilts flash crash case has clearly shown that. When a "safe" asset, which is widely used as collateral in leveraged transactions, falls off the cliff, the ramifications are big. And often hard to digest.
We are at a tipping point! But history often shows that the market often bounces, when we are getting really close to the edge of the cliff. It is really hard for the FED to pivot unless the data strongly supports a U-turn. That's why the next few data points in the US on unemployment and inflation will be key. If the next data points show signs of decelerating inflation and moderating labour market tightness, which is my base case, we have a decent chance to see a relief rally on both rates and risky assets. Market positioning is also stretched, which may add fuel to the bounce. Let's be conscious, though, that if there is no turnaround on data...well, let's brace for further capitulation.
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