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The Case For A Global Liquidity Squeeze

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by: Bernard Keightley
Summary

The global economy can only expand when in expansionary mode.

The reason for that is the USD's role as the de-facto global currency.

Trade policies could derail the leveraging process.

Consider allocating gold to hedge against tail risks.

As Newton's Law would dictate, every action has an equal and opposite reaction - global financialisation is, in many ways, a disease, and as is so often the case, the medicine is likely to be far worse than the disease itself. When liquidity tightens, global leveraging - a cycle which has persisted for decades post-Bretton Woods - will be inevitably disrupted.

And with the escalating trade war threatening to curb liquidity from the global system, I believe we could be set for a material disruption to the global leveraging cycle. With global liquidity risks front and center, investors should consider hedging tail risks by allocating some gold to their portfolios.

Expansion can only occur when the Federal Reserve wants expansion

"The Dollar is our currency but your problem." - John Connally

That infamous statement by John Connally has a certain sense of irony - whilst it was a retort made in jest, it very nicely captures the state of the world today. The global economy in the '60s and '70s recognised a metal (gold) as the universal standard, but today, we recognize a different standard - the USD standard.

The end of the Bretton Woods system was significant because it meant the supply of gold no longer constrained the global economy, and running deficits (into perpetuity) was no longer an issue. The countries that were running surpluses at the time no longer had to worry about their currencies appreciating and the impact that would have on their competitiveness.

Thus, once they were released from the gold standard that had been imposed by the Bretton Woods system, debtor and creditor economies were free to run deficits and surpluses as they pleased, which led to system-wide liquidity expansion. The post-Bretton Woods liquidity boom has created an environment conducive to the mass financialisation of the global economy.

Image result for USD liquidity

Source: Zerohedge

The result has been profound - we now live in a world where the global economy can seemingly only expand when central banks, or rather, the Fed, is in expansionary mode. Perpetual leveraging and re-leveraging have led to increased economic fragility - as I've described in the past, tail risks are emerging on a smorgasbord of indicators. Not only are signs of fragility emerging in conventional economic data points, but also socioeconomic indicators have been flashing red as well.

The influence of the US Dollar

The reason for the Fed's prominence on the global stage is the US Dollar's dominance as a global currency. It is used in the vast majority of global transactions, which exceed US$5 trillion every day, and highlights the US Dollar's status as the major global financial instrument.

For some context, the USD is the preferred currency for over a third of SWIFT transactions. By comparison, the Chinese Renminbi accounts for only approximately 4% of global transactions.

Source: BIS Triennial Survey

The USD dominance extends beyond just trading. The US Dollar's status is also underpinned by the fact that it is used in key financing, trade, and transaction markets. Roughly 80% of global trade pricing and roughly 75% of global cross-border finance is priced in US Dollars. In other words, the USD is an indispensable global value marker.

Compared to every other currency, including the Chinese Renminbi, the US Dollar takes precedence. As such, the Federal Reserve is, via the USD, the default "global" central bank.

Trade escalation could derail the global leveraging cycle

The trade measures currently being taken by the US could have some interesting second-order effects. While the trade policies such as tariffs could bring in some additional revenue, it could result in global demand and liquidity being squeezed further down the line. Furthermore, lower trade could result in reduced global demand for the products and services that the US exports and in turn reduce the potential for economic growth.

For instance, if the US does successfully reduce the trade deficit and brings supply chains back to the US, the US Dollar would presumably strengthen on lower net outflows. Historically, lower trade volumes have coincided with a stronger USD (and vice versa).

Source: Threader

A strong USD would have a tightening effect on liquidity, and potentially disrupt the end of a financialised global economy which relies heavily on rising liquidity and leverage. Note the correlation between volatility (see the VIX gauge below) and dollar liquidity concerns.

Source: Zerohedge

As it is, the supply of the US Dollar is already exceptionally low and appears to have been contracting in recent months. This is being driven by the fact that US current account deficits are steady or declining, lower Fed intervention (note the strong correlation with Fed assets below) and the erosion of the US monetary base (see M1 below).

Source: Zerohedge

Even if the current administration only succeeds in making limited progress in its attempts to reduce current account deficits and disrupt global supply chains, this would mean that countries such as China, Germany, Japan, and Korea would have to revert from their current surpluses. Countries such as Italy, Greece, and Spain would also be (inversely) affected, resulting in profound shifts in global liquidity dynamics. In particular, countries with US Dollar-denominated debt loads could run into trouble - many emerging economies still carry disproportionately high USD debt loads.

Image result for usd debt emerging markets

Source: Wolf Street

Lower trade, reduced liquidity and a limited USD supply could finally be the key to reversing the decades-long leveraging of the global economy post-Bretton Woods. The trade war, in particular, could well be the straw that (finally) breaks the camel's back. After over a year of negotiations, little progress has been made and tensions between both the US and China are on the rise.

From a broader context, with so many risks to global liquidity on the horizon, I believe it is time for investors to be prudent. For instance, I think hedging tail risks should be top of mind in today's uncertain markets - investors should consider allocating gold to their portfolios.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.