Europe’s Biggest Bank Dares To Ask

Why did we focus so much attention yesterday on a post in which the IMF confirmed what we had said since last October, namely that the BOJ’s days of ravenous debt monetization are coming to a tapering end as soon as 2017 (as willing sellers simply run out of product)? Simple: because in the global fiat regime, asset prices are nothing more than an indication of central bank generosity. Or, as Deutsche Bank puts it: “Ultimately in a fiat money system asset prices reflect “outside” i.e. central bank money and the extent to which it multiplied through the banking system.

The problem is that the BOJ and the ECB are the only two remaining central banks in a world in which Reverse QE aka “Quantitative Tightening” in China, and the Fed’s tightening in the form of an upcoming rate hike (unless the Fed loses all credibility and reverts its pro-rate hike bias), are now actively involved in reducing global liquidity. It is only a matter of time before the market starts pricing in that the Bank of Japan’s open-ended QE has begun its tapering (followed by a QE-ending) countdown, which will lead to devastating risk-asset consequences. The ECB, which is also greatly supply constrained as Ewald Nowotny admitted yesterday, will follow closely behind.

But while we expanded on the Japanese problem to come in detail yesterday, here are some key observations on what is going on in both the US and China as of this moment — the two places which all now admit are the culprit for the recent equity selloff, and which the market has finally realized are actively soaking up global liquidity.

Here the problem, as we initially discussed last November in “How The Petrodollar Quietly Died, And Nobody Noticed“, is that as a result of the soaring US dollar and collapse in oil prices, Petrodollar recycling has crashed, leading to an outright liquidation of FX reserves, read US Treasurys by emerging market nations. This was reinforced on August 11th when China joined the global liquidation push as a result of its devaluation announcement, a topic which we also covered far ahead of everyone else with our May report “Revealing The Identity Of The Mystery “Belgian” Buyer Of US Treasurys”, exposing Chinese dumping of US Treasurys via Belgium.

We also hope to have made it quite clear that China’s reserve liquidation and that of the EM petro-exporters is really two sides of the same coin: in a world in which the USD is soaring as a result of Fed tightening concerns, other central banks have no choice but to liquidate FX reserve assets: this includes both EMs, and most recently, China.

Needless to say, these key trends covered here over the past year have finally become the biggest mainstream topic, and have led to the biggest equity drop in years, including the first correction in the S&P since 2011. Elsewhere, the risk devastation is much more profound, with emerging market equity markets and currencies crashing around the globe at a pace reminiscent of the Asian 1998 crisis, while in China both the housing and credit, not to mention the stock market, bubble have all long burst.

Before we continue, we present a brief detour from Deutsche Bank’s Dominic Konstam on precisely how it is that in the current fiat system, global central bank liquidity is fungible and until a few months ago, had led to record equity asset prices in most places around the globe. To wit:

Let’s start from some basics. Global liquidity can be thought of as the sum of all central banks’ balance sheets (liabilities side) expressed in dollar terms. We then have the case of completely flexible exchange rates versus one of fixed exchange rates. In the event that one central bank, say the Fed, is expanding its balance sheet, they will add to global liquidity directly. If exchange rates are flexible this will also mean the dollar tends to weaken so that the value of other central banks’ liabilities in the global system goes up in dollar terms. Dollar weakness thus might contribute to a higher dollar price for dollar denominated global commodities, as an example. If exchange rates are pegged then to achieve that peg other central banks will need to expand their own balance sheets and take on dollar FX reserves on the asset side. Global liquidity is therefore increased initially by the Fed but, secondly, by further liability expansion, by the other central banks. Depending on the sensitivity of exchange rates to relative balance sheet adjustments, it is not an a priori case that the same balance sheet expansion by the Fed leads to greater or less global liquidity expansion under either exchange rate regime. Hence the mere existence of a massive build up in FX reserves shouldn’t be viewed as a massive expansion of global liquidity per se — although as we shall show later, the empirical observation is that this is a more powerful force for the “impact” of changes in global liquidity on financial assets.

That, in broad strokes, explains how and why the Fed’s easing, or tightening, terms have such profound implications not only on every asset class, and currency pair, but on global economic output.

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