A little over a week ago – the Federal Reserve cut interest rates by .25% for the first time since 2008.

And while Jerome Powell – Chief of the Fed – claimed that this isn’t the beginning of an ‘easing cycle’ (when the Fed lowers rates for a long period of time) – I disagree.

Actually – I believe the Fed will begin easing aggressively. And may restart their Quantitative Easing (QE – money printing) program much sooner than many believe. Maybe even as soon as later this year.

Why?

Because financial conditions are getting a lot tighter (meaning: market liquidity’s drying up). And it’s happening at the worst possible time.

For starters – both Republicans and Democrats recently announced a deal to suspend the U.S. debt ceiling and boost federal spending for the next two years (until 2021).

Thus – the U.S. Treasury’s planning to ‘aggressively’ build up its cash balance very soon.

And to give you some context: the Treasury plans on borrowing an additional $433 billion during this quarter (about $275 billion more than it had previously estimated). This is roughly ten times (1,000%) more than what the Treasury borrowed last quarter ($40 billion).

Why does this matter?

Because the Treasury’s sudden cash-grab will intensify global funding problems.

Or – putting things simply – it will suck a significant amount of U.S. dollars out of the banking system – further tightening financial conditions. . .

(Remember – when the U.S. Treasury needs to borrow dollars to pay the bills – it sells bonds. And when it does – foreign nations and primary banks buy these bonds with their surplus dollars or bank reserves. Thus – these dollars flow out from the world economy and back into the Treasury – causing global liquidity to dry up).

Keep in mind that this hefty dollar-drain’s happening at a time when the U.S. dollar’s already becoming increasingly expensive.

For instance – just take a look at the spreads on the U.S. dollar in the five-year currency swap market.

(Note that a five-year currency swap is when two entities exchange money from one currency into another for five years. And during every quarter or so – each entity earns interest in the currency they bought. And pays interest in the currency they sold. Then – at the end of five years – they reverse the trade to close it out).

As of right now – the average premium investors pay to swap euros, Swiss francs, pounds, or many other major currencies into U.S. dollars for five years is negative ten basis points (-10.0).

(A negative spread means that those lending U.S. dollars via swaps want a higher premium. Thus – the more negative the spread becomes – the more severe the shortage of dollars).

This negative swap-spread signals a dollar funding squeeze. And although not terrible yet – it is worsening. (Historically this has been an accurate indicator of coming trouble – as the chart above highlights).

So – putting things simply – U.S. dollars are getting more expensive at a time when markets (and the U.S. Treasury) need liquidity.

Just take a look at the recent ‘Flows and Liquidity‘ report from JP Morgan (JPM). This shows that U.S. dollar liquidity has dried up rather quickly over the last year. And continues doing so.

For instance – the JPM bank model of excess U.S. money supply shows broad dollar liquidity has evaporated over the last twelve months. (Keep in mind that that last time this measure plunged negative like this was during the 2010-2012 ‘euro-zone debt crisis’).

It’s like I can actually hear the sound of a sponge sucking up all this liquidity. . .

But – that’s not all.

This negative dollar-swap spread – and evaporating dollar liquidity – also signals growing fragility and anxiousness in global financial markets. . .

To give you some context: just a couple years ago – the Bank of International Settlements (BIS) discovered that cross-currency swap spreads act as a more accurate ‘measure’ of pain in financial markets and dollar funding issues (i.e. shortage of dollar liquidity). Even more so than the VIX – the volatility indicator. (That’s because during financial uneasiness – dollar demand increases).

Thus – according to the BIS – this increased dollar demand is a sign of financial instability.

I believe it’s clear that financial markets are already very fragile. And that tighter financial conditions in a time when dollar liquidity has already significantly dried up will only add to this fragility.

Thus – the U.S. Treasury’s sudden and hefty cash-grab will only make market’s less liquid. (And since U.S. deficits are only growing – the Treasury will need continuous funding. Sucking more and more dollars out of the system).

So – in summary: the Treasury’s sudden – and much larger-than-expected – funding needs will drain liquidity from the world’s banking system at a time when both U.S. dollar swap-rates and excess dollar supplies (according to JPM) are already signaling tighter financial conditions (and thus financial instability).

This lack of liquidity – meaning shortage of dollars – is happening at a time when the world economy is weakening. Thus making markets much more fragile.

And because of this – I expect that the Fed will be forced to ramp up their monetary easing via aggressive rate cuts and QE sooner than many expect in order to ease financial conditions (aka supply liquidity).

Maybe even as soon as later this year (Q4/2019). . .

Stay tuned.

Did You Like What You Read? Enter your email below and you'll receive my top contrarian insights right when I find them. (PS - I 'll never send you any hype or useless material). And make sure to check out Speculators Anonymous: Premium if you want to receive my top macro-plays and asymmetric (low risk – high reward) opportunities right when I find them plus more. . . We respect your privacy

Related