By
sector, the decline in US stocks was led by the energy (XLE -2.16%)
and the financial industry (XLF -1.24%). While the S&P 500 was
down (-.92%, year to date), the S&P Bank Index ($BIX) was slammed
1.74% (-2.6% week on week and -9.3% year to date). The NYSE Broker
Dealer ($XBD) was hit -2.11% -3.63% w-o-w, -10.73% y-t-d)
The
Stoxx Europe 600 Bank index plummeted 3.7% (-4.8% wow, -23.48% ytd)
to approach a two month low. Deutsche Bank crashed 5.8% (-7.74% wow,
-35% ytd). The FTSE Italia All Share Bank Index plunged 5.03% (down
5.85% wow, 43% ytd) now nears the 2012 lows. Now even before the
Brexit poll announcement, Japan’s Topix Bank ETF dropped 1.31%
(-3.2% wow and -29.44% ytd)
So
while it may be true that Brexit (political risk) could have been a
factor, there must be something else that must have been affecting
financial stocks.
That
other major factor must have been the Chinese yuan.
Last
May 28, I wrote that the USD-yuan was making strides to hit its
previous highs. While the Chinese went into a 5 day holiday to
celebrate the Golden Week Spring Festival and because of this, the
onshore yuan CNY was last traded to reflect on a rebound mostly in
reaction to the weak US payroll data of the other week, the offshore
yuan got clobbered.
By
Friday, the offshore yuan (CNH) suffered its biggest weakly decline
since March (Bloomberg).
Importantly, the CNH appears to have outpaced the CNY which like in
August and January incited a global asset convulsion.
And
if you haven’t noticed, the strains on the China’s yuan have
appeared like clockwork—every SIX months.
And
why shouldn’t this happen? The January yuan (deflationary) strain
has prompted the Chinese government to unleash a staggering USD 1
Trillion of Total Social Financing (lowest window)! And the magnitude
of credit expansion perked up domestic liquidity which subsequently
caused food inflation even when the general measure of inflation the
CPI barely budged.
From
the supply side alone, the flood of credit by itself should be
indicative that the yuan is southbound or headed lower!
So
it is likely that such developments may have prompted those in the
know to escalate capital flight.
China’s
reserves have most likely been propped up by derivatives, (forex
swaps and futures contracts). And with such derivative tools being
short term in nature, borrowed dollars will again need to be paid
back or rolled over. So the 6 months cycle could have signified
expiring contracts.
Again
China’s currency ailment could be a symptom or a manifestation of
the escalating pressure on the US dollar “shortages” through
wholesale finance, in particular fx swaps and forward contracts.
In
a recent speech by Bank for International Settlement’s, Economic
Adviser and Head of Research, Hyun Song Shin, Mr Hyun opined that a
critical measure of the foreign exchange markets have broken down or
in his words a “widespread failure”.
Such
systematic failure which has become pronounced in the last 18 months
have been seen through the Covered Interest Rate Parity (CIP)
Covered
Interest Rate Parity is “a condition where the relationship between
interest rates and the spot and forward currency values of two
countries are in equilibrium” (Investopedia)
In
short, the relationship between interest rates and currency values
has been rendered dysfunctional.
For
an overview. A currency’s forward rate and the current “spot”
rate provides for the implied interest rate on the US dollar. Thus
the difference between Libor and FX swap-implied dollar interest rate
is called “cross-currency basis”
And
when the implied interest rate from the fx dollar swap is above
Libor, then the borrower of dollars will be paying more than the
rates at the open market.
The
systemic failure or breakdown occurs when cross currency basis have
consistently been in negative, or when the fx swap dollar borrowers
are, as noted above, paying above the market rates.
Negative
cross currency basis occurred during the Great Recession. Today it
has been happening for the 18 months even “during the period of
relative calm”
But
such correlational breakdown has been anchored on a strong US dollar
which is a symptom of tighter credit conditions.
Mr
Hyun*
The
breakdown of covered interest parity is a symptom of tighter dollar
credit conditions putting a squeeze on accumulated dollar liabilities
built up during the previous period of easy dollar credit
*Hyun
Song Shin Global
liquidity and procyclicality World
Bank conference, “The state of economics, the state of the world”
Washington DC, 8 June 2016 Bank for International Settlements
Ironically,
the CIP breakdown has not been seen only in emerging markets but in
the yen, Swiss franc and the euro. Yes negative rates economies!
And
these accumulated dollar liabilities or “ dollar shorts” emanate
from three aspects of the US dollar’s currency reserve and cross
border transaction role: namely, trade finance, invoicing currency
and funding currency.
As
trade finance currency, hedging activities are usually channeled
through US denominated bank credit.
As
invoicing currency, borrowing and lending occurs on the currency from
which trade has been denominated in. For instance, exporters who
trade in US dollars tend to borrow US dollars to finance operations
and real assets.
As
funding currency, globalization of financial markets means that a
significant number of financial- institutions (such as pensions) or
investors invest or take advantage of trade or speculative arbitrages
around the world. In doing so, they convert foreign currency to
domestic currency where investments are made. This leads to currency
mismatches which these institutions or investors apply hedge
positions. And the hedging counterparty is typically a bank. And as
consequence, the bank will likely resort to mitigating its currency
risk exposure by borrowing dollars. In this way, dollar claims are
counterbalanced by dollar debts.
In
other words, dollar liabilities built the period of easy dollar
credit are equivalent to dollar "shorts".
So
when credit conditions tighten, the race to meet dollar obligations
are magnified, hence fx borrowers to pay above market rates to cover
dollar “short” positions or dollar liabilities. This leads to the
systemic CIP failure. Thus the recent rise of the US dollar, which
has been accompanied by the negative cross currency basis, means that
global conditions have been tightening.
I
might add that such correlational breakdown have also been tied with
ZIRP, NIRP and QE which provided the “period of easy dollar credit”
and the incentives to hedge and leverage up in USD.
Aside
from the above mentioned strains, China’s weakening currency could
be in part, brought about dollar shorts and also in part from a
stampede to meet such obligations.
The
BIS’ latest outlook on China’s external credit conditions
provides some clues [Bank for International SettlementsHighlights
of the BIS international statistics (June
6, 2016)] "Cross-border bank credit to emerging market economies
(EMEs) was down by $159 billion during Q4 2015, or 8% in the year to
end-December 2015 – the sharpest year-on-year contraction since
2009” And this was largely due to China where “ The $114 billion
decline in cross-border lending to China was the second quarterly
drop in a row, and it pushed the annual growth rate down to –25%.”
Furthermore,
“The $114 billion decline in cross-border lending to China was the
second quarterly drop in a row, and it pushed the annual growth rate
down to –25%.”
And
for potential supply of dollar shorts “New data published by China confirm
that banks on the mainland are becoming an increasingly important
source of international bank credit. They are an especially important
source of US dollar credit: their cross-border dollar assets totalled
$529 billion at end-December 2015."
So
if there is anything, the bank selloffs and yuan’s weakening are
symptoms of the ongoing tightening credit conditions around the
world.
And
tightening credit conditions should extrapolate to a weaker economy
and narrowing access to credit. This subsequently implies greater
credit risk which should transpose into greater systemic fragility.
Is
it a wonder now why George Soros made a huge bet on a market crash
and called for a sell on Asia?
