There is a dollar funding and liquidity crisis afoot. The US is currently having an increasingly hard time funding its current account deficits, which means that the Federal Reserve will have to lose control of its balance sheets to keep control of interest rates.
We have already seen signs of this with the repo operations in September. At this stage, we are not sure that the Fed will move fast enough on balance sheet expansion to turn the dollar lower, but we’re certain that the Trump administration will make its move to help out if not.
This is likely to be an interesting quarter for the dollar, which could finally start to turn lower. When the dollar turns lower is interesting because at the same time we are concerned about the global growth cycle — and this means the pattern of weaknesses and strengths could be very different depending on the economic growth outlook.
We have been trying to call the US dollar weaker this year, with the caveat that the path might prove difficult as the Fed would have to get ahead of the curve; so far it has not moved fast enough after the policy mistake of hiking rates too high in 2018. Market expectations are that the Fed’s policy path will remain largely unchanged to very slightly lower. Also, the Fed may not have the tools — or more importantly the will — to weaken the dollar.
That said, the Trump administration is likely to lend a hand in weakening the dollar. The reality is that Donald Trump wants a weaker US currency for US exports to rise. He has even formed a committee to investigate how to weaken the currency.
A weaker dollar could help US businesses compete globally by making exports less expensive, boosting the economy and potentially helping Mr Trump’s bid for re-election in 2020. As the US dollar is a global reserve currency, for it to weaken, other currencies will have to rise. This could prove to be a challenge as other countries have already begun to ease monetary policy to support their economies, and their policy moves have also helped to keep their currencies weaker, supporting trade advantages.
After the realisation that hiking policy rates in cratering markets in December 2018 was a policy mistake, the Fed’s subsequent turnaround and easing has proceeded at a slower pace than needed to weaken the dollar. This is the case even after the initial shock reversal in rhetoric by admitting the policy mistake in January of this year.
While two 25 basis point Fed rate cuts are in the bag from the July and September Federal Open Market Committee meetings — and at least one more is priced for the fourth quarter — US dollar liquidity and funding issues in the US banking system have become so dire that the Fed was forced to launch a large overnight repo operation the day before the September meeting to maintain control of funding rates. This is a major crack in the Fed’s credibility and effectively tips the market off that it is losing control of its balance sheet.
The fact that this issue could sneak up on the Fed so easily should be of concern, hinting that the central bank could remain slow in responding to further US dollar liquidity issues. At the September FOMC meeting, chairman Jerome Powell suggested an ad hoc or Tomo (temporary open market operations) approach to dealing with funding pinches like those that led to their September repo operations, rather than immediately opening up for the idea of Pomo (permanent open market operations, or essentially quantitative easing) just yet.
The main force driving US dollar’s liquidity/funding issues is the mounting difficulty the country is having in funding its current account deficit. This is driven by the twin trade and Trump administration deficits — the latter having ballooned to a $1 trillion (Dh3.67tn)-a-year clip under Mr Trump’s tax cut regime.
As foreign central banks have lost their ability, and interest in, accumulating US dollar reserves, the funding for these deficits has largely shifted to domestic sources. US savers’ and US banks’ balance sheets simply cannot absorb the torrent of issuance. Something has to give, and that something will be the Fed: whether it wants to or not.
So far, the Fed has proven too cautious to get ahead of the issue. But in the fourth quarter, it is likely they will be forced to respond in ever larger amounts to further liquidity provision. More importantly, the Trump administration may wrest control of policy.
Its lofty talk of political independence aside, the Fed cannot entirely avoid politics. And going full in on resuming balance-sheet expansion to control policy rates acts as a powerful endorsement of Trump administration deficits, something it is not likely happy about.
A heel-dragging Fed almost ensures the Trump administration will be scrambling for the funding it needs to bring any boost to the economy and markets that it can ahead of Trump’s re-election bid in 2020. Ironically, after a quarter in which the entire world fretted the risk of perma-deflation, this policy mix almost guarantees that we are set firmly on the path to the return of inflation, and likely stagflation lite at minimum.
John Hardy is head of FX strategy at Saxo Bank
