Do Central Banks Need A Plumber?

Equity & Cross Asset Strategy
16th September 2015
Paul Mylchreest
Tel: +44 20 7716 8257
Email: paul.mylchreest@admisi.com
Do Central Banks Need a Plumber?

Eurodollar - Global Fed Funds rate, weaponisation and emerging
liquidity shortage
We acknowledge that the financial systems plumbing is not a subject that equity investors
are usually prepared to immerse themselves in, but it has left them behind the curve on
more than one occasion.
Historically, problems in financial markets have arisen in the wholesale money (e.g. LIBOR,
repo) and/or forex markets, before spilling over into other parts of the system. There are
stresses in both and it would be unwise to dismiss them without in-depth evaluation.
Our analysis suggests that there is an emerging Eurodollar liquidity shortage - which extends
into wholesale and shadow banking markets - and is exacerbated by currency/maturity mismatch. Eurodollars are dollar deposits held in offshore accounts outside the US.
Regulatory change and Fed policy (QE 2/QE 3) contributed to the tightness in Eurodollar
liquidity, leading to a huge inflow of dollars (US$1.0 trillion) on the part of foreign banks from
offshore Eurodollar markets into domestic US money markets in 2011-14. The recent reversal
suggests that foreign banks might be trying to shore up Eurodollar operations.
1
ADM Investor Services International Limited is authorised and regulated by The Financial Conduct Authority. Member of The Lon don Stock Exchange. Registered office: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland
Company. Risk Warning: Investments in Equities, CFDs, Futures, Options, Derivatives and Foreign Exchange can fluctuate in val ue, investors should therefore be aware that they may not realise the initial amount invested, and indeed may incur additional li abilities. These Investments may entail above average financial risk of
loss, and investors should therefore carefully consider whether their financial circumstances and investment experience permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United
Kingdom or elsewhere. 2014 ADM Investor Services International Limited 2014.

Paul Mylchreest
Tel: +44 20 7716 8257
It is looking increasingly like the Eurodollar is taking on a role akin to a Global Fed Funds
rate. Investors may have underestimated the degree to which a rising dollar transmits tighter monetary policy across an already misfiring global economy, especially when it is carrying
US$10 trillion (+70% since 2008) in offshore Eurodollar debt.
From a Chinese (especially) and EM standpoint in particular, it is becoming increasingly clear
that the dollar has been weaponised. While the Fed is using existing bilateral agreements
to expand much-needed dollar swaps to other DM central banks (likely including the Bank of
England on a covert basis...for HSBC or Standard Chartered we wonder?), the lack of a dollar
swap arrangement with the PBoC is a glaring omission.
We believe that the Chinese sell-off in foreign exchange reserves and US Treasuries has been
more to do with providing wholesale Eurodollar liquidity to its banking system, rather than
supporting the peg per se. This is harming stability and risks stoking a deterioration in relations between China and the US over the dollar issue.
Besides rapid transmission of US monetary policy to the rest of the world, Fed tightening is
complicated by the changed mechanics of implementing a rate increase, now that the Fed
Funds route is ineffective. The proposed new mechanism (Overnight Reverse Repo) is more
deeply integrated into the shadow banking system and might have adverse knock-on
effects to the plumbing as we explain.
The financial system is considerably more fragile than most commentators (and central
banks) are prepared to acknowledge. The biggest test for the plumbing lies ahead of us.
Our cautious stance towards equities highlighted in the 6 July 2015 report titled rather longwindedly S&P500: technical indicator which called the 2000 & 2007 peaks gives first sell signal for current bull market in Equities remains in place - as does our preference for defensive
positioning in sectors and stocks.
It is beyond the scope of this report, but sectors which could be at risk include (obviously)
Banks any escalation of problems in the plumbing is not priced in along with Capital
Goods and Autos.
2
ADM Investor Services International Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered office: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland
Company. Risk Warning: Investments in Equities, CFDs, Futures, Options, Derivatives and Foreign Exchange can fluctuate in value, investors should therefore be aware that they may not realise the initial amount invested, and indeed may incur additional liabilities. These Investments may entail above average financial
risk of loss, and investors should therefore carefully consider whether their financial circumstances and investment experience permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints
either in the United Kingdom or elsewhere. 2014 ADM Investor Services International Limited 2014.

Paul Mylchreest
Tel: +44 20 7716 8257
Contents
Introduction its all about the plumbing
Eurodollars in 2007-08
Eurodollar flows since the crisis
13
Mid-2014: Eurodollar liquidity tide starts to ebb and the world changes
21
Eurodollar liquidity shortage becomes more apparent
31
China caught in the squeeze
44
Fed policy now complicated by shadow banking
52
Financialism and defensive stance on Equities
58
3

Paul Mylchreest
Tel: +44 20 7716 8257
Introduction its all about the plumbing

The longer weve analysed financial markets, the more weve realised the importance of picking up
nuances coming from the plumbing in the financial system as early as possible.
In Replumbing our Financial System: Uneven Progress, Darrell Duffie of Stanford University commented.
Plumbing is a common metaphor for institutional elements of the financial system that are fixed in
the short run and enable flows of credit, capital, and financial risk. This institutional structure includes some big valves and pipes that connect central banks, dealer banks, money-market funds,
major institutional investors, repo clearing banks, over-the-counter (OTC) derivatives central clearing
parties, and exchanges. The connectors include lending facilities offered by central banks to each
other and to dealer banks, triparty repo and clearing agreements, OTC derivatives master swap
agreements, prime-brokerage agreements, and settlement systems
Looking back at the emergence of previous problems, they usually began in wholesale money markets
(e.g. LIBOR, repo, etc.) and/or forex markets before spilling over into other parts of the financial system. Currently stresses are emerging in both.
In todays markets, the consensus view has been that staggeringly heavy-handed central bank intervention including the US$10 trillion of additional credit creation - would not have unintended consequences.
Source: ADMISI, Bloomberg
However, our contention is that after seven years of extreme intervention, the plumbing in the system is becoming stressed.
4

Paul Mylchreest
Tel: +44 20 7716 8257
The initial signs of stress emerged in early 2014 with the unexpected weakness in the Chinese Yuan.
While its relevance was glossed over at the time, the stress started to become more obvious in the middle of 2014. We dont think that its overstating the situation, as we argue in the report, to say that the
world changed from that period onwards and hasnt changed back (yet anyway).
The end of June last year coincided with the beginning of the strong upward move in the US dollar and
the subsequent breakout of the US dollar from a wedge which had been 30 years in the making.
When we say dollar, we also mean Eurodollar, i.e. offshore dollars.

The US dollar stands at the centre of the financial system, given its dominance in trade and its reserve
currency status.
If we are correct, the US dollar is acting like a quasi Global Fed Funds rate.
This reflects the link between the dollar exchange rate and,
The transmission of US monetary policy to the rest of the world;
The 70% expansion of offshore Eurodollar debt to more than US$10 trillion since 2008;
Global economic growth;
Liquidity in wholesale money markets and shadow banking;
Financial stability; and (potentially)
US/China economic relations.
5

Paul Mylchreest
Tel: +44 20 7716 8257
Dollars, dollars everywhere but

As far as we can tell, there is an emerging shortage - essentially a run - in dollar liquidity which is
focused on Eurodollars.
We believe that the main reason that EM central banks, notably the PBoC, are resorting to selling
forex reserves and US Treasuries is to provide wholesale dollar liquidity to their respective banking
systems (and helping to address issues of maturity mismatch).
The Fed is extending dollar swaps with other central banks (almost certainly the BoE) which may be
alleviating the liquidity shortage somwhat in DM economies. However, the omission of EM central
banks, especially the PBoC, could be a serious miscalculation.
The global economy is credit (debt) driven - making global growth dependent on the provision of incremental credit.
In the US, total debt (including the US$4.5 trillion on the Feds balance sheet) has reached US$64.0
trillion. The law of (very) big numbers is kicking in, which is leading to a structurally lower level of
nominal GDP growth. Indeed, the current level has corresponded with most of the recessions of the
last (more than) 50 years.
In China, like many others, we have serious doubts about the GDP statistics, but the rate of credit
growth, according to its broadest measure, has slowed substantially. It is now the lowest on record.
6

Paul Mylchreest
Tel: +44 20 7716 8257
An alternative way of looking at dollar liquidity supplied by the banking system is the volume of outstanding derivatives held by US banks - which has been declining since 2013.
Source: OCC
In a credit driven economy, the nexus for transmitting credit into growth is a combination of:
The banking (including shadow banking) systems balance sheet on a global basis; and
The day-to-day and month-to-month attitude of Portfolio Managers - given the growing percentage of credit raised in global bond markets.
Both are pro-cyclical which makes it risky to dismiss signs of a liquidity squeeze in the worlds major
currency and other factors (e.g. Basle III Leverage Ratio) which could pressurise balance sheets and investment attitudes across the financial system.
Its been noted time and time again, that credit markets are smarter than equity markets. Its early
days but we continue to track the flow of capital from riskier to safer assets across the credit complex.
7

Paul Mylchreest
Tel: +44 20 7716 8257
We can illustrate this using some of the large credit ETFs. Investment Grade Corporate (LQD) is outperfoming High Yield (HYG).
And the long Treasury ETF (TLT) is outperforming Investment Grade Corporate (LQD).
We believe that the biggest test for the post-crisis financial system probably lies ahead of us, not behind us (e.g. with the Eurozone debt crisis).
8

Paul Mylchreest
Tel: +44 20 7716 8257
Eurodollars in 2007-08
The functioning of the wholesale dollar market, which is effectively the heart of the worlds dollarbased financial system, broke down on 9 August 2007 after BNP Paribas stopped redemptions on three
investment funds. That date marked the start of a scramble for dollar liquidity - especially Eurodollar
liquidity which continued for more than eighteen months.
According to the FRBNY.
The financial crisis that began in August 2007 disrupted U.S. dollar funding markets not only in the
United States but also overseas.
The chart below perfectly illustrates how dollar liquidity bifurcated into what were effectively two separate wholesale dollar money markets.
London:
LIBOR
New York: Fed Funds
Eurodollars; and
domestic dollars
With Fed support, dollar liquidity was plentiful in New York, while it was much tighter in Europe
(especially London) and elsewhere. In essence, the bifurcation of the dollar resulted from a credit
crunch in which domestic US money markets had access to Fed liquidity while Eurodollar markets did
not.
9

Paul Mylchreest
Tel: +44 20 7716 8257
This was Zero Hedges Tyler Durden on the subject with our emphasis.
this systemic dollar shortage was primarily the result of imbalanced FX funding at the
global commercial banks, arising from first Japanese, and then European banks' abuse of
a USD-denominated asset-liability mismatch, in which the dollar being the funding currency of choice, resulted in a massive matched synthetic Dollar short on the books of
commercial bank desks around the globe
The synthetic dollar short is now far larger- in excess of US$10 trillion as discussed below. However,
we wanted to review what happened in 2007-08 even though current events are unfolding differently
thus far.
Back to 2007and the very short-term funding nature of wholesale money and shadow banking
(mostly overnight or three months) markets led to problems in rolling over wholesaale dollar funding
outside the US. This prompted the run on Eurodollars and 3-month LIBOR moving to a significant
premium to Fed Funds.
Less than two years earlier, in October 2005, the New York Fed had issued a report Money Market
Integration which proved to be catastrophically inaccurate. It concluded.
The two core components of the unsecured overnight bank funding market - the market
for federal funds and the market for Eurodollars - are well integratedFrom the viewpoint of policy
design and analysis of the transmission of monetary policy, our results suggest that it makes little
difference that the Federal Reserve targets only rates in the federal funds market, and does not include trades executed in the larger Eurodollar market into its target.
In 2007, as the Eurodollar shortage intensified, the players which were most depenedent on short-term
Eurodollar funding were European banks. In its report, The Financial Crisis and US Cross-Border Financial Flows, the US Treasury commented that.
When ABCP markets froze in the fall of 2007, European banks not only lost a source of new funding,
but also needed to pay off the commercial paper and medium-term notes maturing throughout late
2007 and early 2008 that could not be rolled over in the market. Because many of the assets backing
the commercial paper were illiquid, European banks needed other sources of U.S. dollars.
Today, we suspect that its banks operating in the EM economies, especially China, Hong Kong and Brazil, which are beginning to feel the most pressure in dollar funding.
An important lesson from the 2007-08 Great Financial Crisis was that there are effectively two
inventories of dollar credit one which is domestic US and one which is offshore, i.e. Eurodollars.
Eurodollars are basically short-term obligations/deposits for dollar payment which are held at banks
outside the US avoiding US banking regulation and formal reserve requirements. In most cases, Eurodollars are generally used to finance longer-term loans and securities, so there are often critical maturity (and currency) mismatches.

Paul Mylchreest
Tel: +44 20 7716 8257
To quote the BIS (from Working Paper 483 Global dollar credit: links to US monetary policy and leverage from January 2015).
There is only one federal funds rate and only one dollar Libor, but there are two stocks of dollar debt
responding in very different fashion to these interest rates. From a time series perspective, the offshore aggregate has behaved quite differently from its larger US aggregate, not least since the global
financial crisis
The (Euro) dollar shortage and flow of dollars from New York to London was visible in the monthly
Treasury International Capital data. Note in particular the downward spikes, i.e. net dollar outflows, in
August 2007 and end-2008/start-2009.
Keep this chart in mind as well show an up-to-date version below which implies that the tightness in
Eurodollar liquidity has returned.
Responding to the situation, the Fed stepped in with dollar swaps with foreign central banks beginning
in December 2007. Here is the FRBNY again.
To address funding pressures internationally, the Federal Reserve introduced a system of reciprocal
currency arrangements, or swap lines, with other central banks.
This led to the short-term reversals in dollar outflows in late 2007 and the larger one at the end of 2008
which can be seen in the above chart.

Paul Mylchreest
Tel: +44 20 7716 8257
According to the US Treasury

Through much of the crisis, banks located in the United States played a primary role in funding dollar needs abroad. During the height of the crisis in the fall of 2008, however, foreign central banks
provided dollars, drawn from their swap lines with the Federal Reserve, to foreign banks directly.
when the Feds dollar swaps peaked at more than half a trillion.
the Federal Reserve dramatically increased the availability of dollars to foreign central banks
through liquidity swap facilities. Outstanding amounts drawn on the swap lines reacheda peak of
$554 billion at the end of December 2008. More than three-fourths of these funds were drawn by
central banks in Europe. Because of the swap lines, the foreign banks that had been borrowing heavily from their U.S. offices were able to obtain dollars directly from their own central banks. In response, the U.S. offices of many of those foreign banks were able to decrease their lending position
to their parents, receiving a flow of funds back into the United States between September and December of 2008.
From our research, we believe that the Fed has started to extend new dollar swaps to DM central banks
but not EM (which is significant). Before we address that, lets look at Eurodollar flows since the crisis.

Paul Mylchreest
Tel: +44 20 7716 8257
Eurodollar flows since the crisis

There are effectively two inventories of dollar credit/debt as outlined above, one which is domestic and
the other which is offshore, i.e. Eurodollars.
These two dollar inventories are inter-linked and effectively in competition with each other, given the
different investment opportunities/rates and regulatory frameworks overseas compared with the US.
The functioning of both the domestic and Eurodollar credit inventories are dependent on the efficient
performance of several wholesale money and shadow banking markets including Fed Funds (domestic
US), LIBOR (Eurodollars), repo, currency swaps and, in times of stress, the provision of dollars by central
banks.
Below we show how in recent years banks have moved huge volumes of dollars from offshore Eurodollar markets into domestic US money markets. This has been a response to regulatory change in
the US and Fed policy (QE2, QE3 and IOER). This has contributed to the shortage of Eurodollar liquidity. Since mid-2014, this flow started to reverse which seems to reflect measures on the part of
banks to shore up their Eurodollar funding needs.
The analysis will first consider flows relating to US branches of foreign banks followed by US-chartered
banks and then the aggregate of both categories.
At the peak in late 2008, US branches of foreign banks were raising almost US$600bn in domestic US
wholesale money markets and transferring them into overseas Eurodollar markets in order to accumulate dollar assets (e.g. securities and loans) a round trip of sorts. On the other side of the crisis (e.g.
2009-10), the volume of dollars supplied into Eurodollar markets from the US by foreign banks was lower, but still substantial, at around US$400bn.


Paul Mylchreest
Tel: +44 20 7716 8257
Then something major happened (in a regulatory sense) going into 2011 which led to a dramatic
change in the balance sheets of US branches of foreign banks.
In April 2011, the FDIC assessment base (tax) on banks was widened from Deposits to Assets less Tangible Shareholders Equity. This applied to US chartered banks only and not US branches of foreign
banks.
The change had a major impact on flows of dollars in wholesale money markets.
The increased cost burden to US chartered banks was recovered via lower wholesale funding costs, e.g.
3-month LIBOR fell by 6-7 basis points and repo rates fell by 10-15 basis points during February-May
2011.
US branches of foreign banks, which were unaffected by the FDIC change, were better placed than their
US counterparts to earn the free profit on the arbitrage between wholesale funding costs and 25 basis point interest paid by the Federal Reserve on excess reserves (IOER). And bank reserves were in
the process of receiving a large boostthanks to the Fed.
This was why US branches of foreign banks were disproportionately active in the Feds US$600bn QE2
programme, which was coincident with the FDIC assessment change. And notice how the next enormous surge in dollars flowing from overseas to domestic US occurred with the implementation of the
much bigger QE3 (over US$1.6 trillion) in November 2012.
So US branches of foreign banks flipped from being providers of US$400bn of funding into overseas
Eurodollar markets at the beginning of 2011 to sucking in US$600bn of funding from Eurodollar markets into their US operations by mid/late-2014.
This represented an enormous swing in flow of approximately US$1.0 trillion in favour of domestic
US money markets versus offshore Eurodollar markets.
Its not surprising that these capital flows led to significant changes in the respective balance sheets of
foreign branches of US banks and their domestic counterparts. These changes included:
The relative balance between funding via wholesale money markets versus deposits;
The relative participation in domestic US money markets; and
The buildup of excess reserves (held at the Fed) on the asset side of their balance sheets as a result of QE.
In July 2014, the US Office of Financial Research published a paper Shadow Banking: The Money View
by Zoltan Pozsar. While it specifically compares the period from Q2 2007 to Q3 2013, it still shows the
near US$1.0trn shift in dollar funding (detailed above) for US branches of foreign banks compare the
yellow bars (GDF = Global Dollar Funding) at the two dates.

Paul Mylchreest
Tel: +44 20 7716 8257
Source: Office of Financial Research
The gold bar in the assets category shows the dramatic impact of QE on the balance sheets of foreign
banks operating in the US.
The report makes this comment on dollar/Eurodollar flows.
Segment [1] shows thatthe volume of global (or interoffice) money dealing by these branches
went from raising $400 billion in the U.S. money market and lending it to headquarters globally in
order to fund Eurodollar lending, to raising over $500 billion in Eurodollar markets and funnelling
(sic) these back to the United States to fund reserves at the Federal Reserve.
And this one on the increase in participation in US wholesale markets by foreign banks:
Segment [2] shows that over the same period the volume of domestic money dealing by the New
York branches of foreign banks rose from just under $300 billion to nearly $1.5 trillion, or from 20
percent to 65 percent of total assets.
If we examine the recent data on dollar flows in the banking system, the chart below shows that the
flow of (Euro) dollars back to the US peaked during the first ten months of 2014. Beginning in November 2014, there was a sudden reversal in this longstanding trend, which has since remained in place.

Paul Mylchreest
Tel: +44 20 7716 8257
Why the US$300bn - currently still over US$200bn - sudden reversal in late 2014?
This looks like a defensive move, possibly to cover Eurodollar funding needs outside the US.
Now lets contrast US branches of foreign banks with dollar flows for US-chartered banks.
US banks did the opposite to foreign banks, but on a smaller scale. US banks began repaying all of their
net wholesale (Eurodollar) funding following the crisis period of late 2008. This process accelerated with
the FDIC assessment change in 2011.

Paul Mylchreest
Tel: +44 20 7716 8257
These dollar flows can be seen in the roughly US$270bn swing during 2008-10 and additional US$450bn
swing during 2011-13. In aggregate, therefore, US banks reversed their dollar funding by around
US$720bn from net Eurodollar funding of their US operations of roughly US$620bn to a position of supplying a net US$100bn or so from the US into overseas Eurodollar operations.
Since the beginning of 2013, the chart shows a renewed reversal of about US$200bn around the net
zero point. US banks have shifted from a net US$100bn of domestic US funding for Eurodollar usage to
utilizing US$100bn of Eurodollar funding domestically.
Moving on to domestic US banks and here is the balance sheet comparison between Q2 2007 and Q3
2013.
Source: Office of Financial Research
The report backs up our earlier comments about US banks reduction in Eurodollar funding (yellow bar).
On net, U.S. banks raised about $400 billion of dollar funding in Eurodollar markets globally during
the second quarter of 2007, less than 5 percent of total assets (see yellow rectangle on the liability
side of the chart). This amount has fallen to marginal amounts since then.
The other major change for US banks was a far greater reliance on deposits versus all forms of wholesale funding on the liability side of their balance sheets the latter having declined to negligible levels.
On the subject of wholesale funding of bank balance sheets, its noteworthy that the FDIC assessment
change and QE led to a situation where US banks have minimal participation in domestic wholesale
funding markets. In contrast, US branches of foreign banks are now the dominant players, by far.

Paul Mylchreest
Tel: +44 20 7716 8257
Its hard to imagine that this isnt making the Federal Reserve nervous about the transmission of changes in monetary policy going forward.
Now lets look at the aggregate dollar flows of foreign and domestic US banks.
While the dollar flows of foreign and domestic banks have generally been in opposite directions, there
has been an overwhelming net flow of (Euro) dollars into the US.
During 2011-14, the aggregated flows of both groups of banks are summarized in the following chart
which shows a roughly US$800bn net inflow of dollars from offshore Eurodollar markets into the US.
The aggregate flow clearly breaks down into three periods.
US$450bn during the first half of 2011 - helped by the anticipation and implementation of the
FDIC assessment change and the Feds QE2;
A US$350bn reversal during mid-2011 to end-2012 which was between Fed QE programmes
and also reflected the large scale withdrawal of US banks from accessing funding from domestic
money markets (and switching to deposits); and
US$700bn flow during 2013-14 as QE3 was implemented.
As we showed, foreign banks have accounted for almost all of this capital flow as the BIS explained:
In other words, dollar funding flowed into the US through non-US headquartered banks
balance sheets. Far from funding offshore dollar loans, interbank flows competed with such loans for
dollar funding.

Paul Mylchreest
Tel: +44 20 7716 8257
Its worth emphasizing that last point made in the BIS paper that (Euro) dollar flows into the US have
competed with the funding of offshore Eurodollar loanswhich has contributed to the run on Eurodollar liquidity.
Following on from this, we find it very interesting that there was a sudden US$300bn (and still over
US$200bn) reversal during very late 2014 to the first few days of 2015.
Foreign banks were suddenly repatriating dollars back to their Eurodollar operations. Why might that
be?
Was it just down to the end of QE3? We dont think so. Its not as though the Feds IOER was suddenly
reduced.
As we said earlier, we think that it was a defensive move on the part of foreign banks. In our opinion, it
likely reflected the tightening in Eurodollar liquidity and a sudden need to shore up Eurodollar funding
in overseas operations.
It seems that the issue of dollar liquidity is more serious than most people realise.
We could be wrong, but it looks to us as though theres been a run on Eurodollar liquidity and one
that has been at least as severe as on three occasions as 2007-08 based on the Treasury International
Capital (TIC) measure of capital flows.

Paul Mylchreest
Tel: +44 20 7716 8257
The three occasions were:
The beginning of 2014 - just prior to initial Yuan devaluation (see below);
Mid-2014 when so many economic indicators changed direction and the dollar began its major
rise; and
End-2014 when foreign banks suddenly moved about US300bn overseas from US money markets.

Paul Mylchreest
Tel: +44 20 7716 8257
Mid-2014: Eurodollar liquidity tide starts to ebb and the world changes
The world changed in mid-2014, but the initial tremor in terms of tightening dollar liquity was the
PBOCs unexpected devaluation of the Yuan versus the dollar in February 2014. Between earlyFebruary/late-April 2014, the Yuan/Dollar rate rose 3.9% from 6.025 to 6.258.
Back then, the PBOCs action was subject to much debate. Many commentators ascribed it to slowing
economic growth and the need to boost exports This should sound familiar vis--vis 2015.
The more savvy pointed to the need to change the view that the Yuan was a one-way trade, which was
leading to a build up in the short dollar/long Yuan carry trade. These fears are coming home to roost.
Other commentators also noted the authorities desire to rein in the huge distortions and rampant
growth in Chinas shadow banking system. This included loans collateralised with commodities (e.g.
copper) and high-yielding Wealth Management Products (WMPs) following the default, and subsequent opaque (state-backed?) bailout, of the US$500m Credit Equals Gold No.1 product in January
2014.
Then there were one or two, like the FTs Izabella Kaminska, who connected all of the above - the
weaker Yuan, carry trade and shadow banking - with dollar liquidity. From her article, The Curious Incident of the PBOC in the USDCNY market with our emphasis.
But one other explanation is that outstanding USD shorts (a la the China RMB carry trade, which
loosely involves Chinese companies borrowing USD via Hong Kong against all sorts of collateral, converting it into CNH, reinvesting it domestically in high-yielding CNY instruments, and waiting for CNY
to appreciate) are unravelling on their own accord. It is a shortage of USD liquidity, in other words,
which is encouraging the liquidation of CNY instruments and their respective conversion into CNH
and then USD

Paul Mylchreest
Tel: +44 20 7716 8257
Basically, Chinese banks - no doubt with the approval of the PBoC - bid more aggressively for (Euro)
dollars in wholesale funding markets which weakened the Yuan.
The beginning of 2014 saw the bottoming out in Overnight LIBOR, i.e. the cost of borrowing Eurodollars overnight. It surged in late 2014 when Eurodollar liquidity tightened considerably, continuing to
rise even after the FOMC signaled that an imminent rate rise would be delayed on 18 March 2015.
Although this initial tremor was quickly forgotten, it was followed in mid-2014 (as we mentioned
above) by the beginning of the upward move in the dollar in terms of the DXY.

Paul Mylchreest
Tel: +44 20 7716 8257
The start of this move coincided with a series of warning signs across a range of financial market and
economic indicators giving it greater significance in our opinion.
For example, there was a general spike in currency volatility.
We saw a low in the MOVE Index (Merrill Option Volatility Estimate), which gauges volatility in the
Treasury market.

Paul Mylchreest
Tel: +44 20 7716 8257
And a low in the VIX.
Rates on junk bonds bottomed and began a sharp rise.

Paul Mylchreest
Tel: +44 20 7716 8257
There was the high in the Global Manufacturing PMI.
We had the start of the huge fall in crude oil and the low in WTI volatility, before the subsequent spike.
Something else occurred in mid-2014, which escaped comment at the time, but suggested emerging
liquidity strains in wholesale dollar markets. The concept of dollar liquidity reaches deeply into the
realm of shadow banking both in the US and overseas, especially in key financial centres like London
and China/Hong Kong.

Paul Mylchreest
Tel: +44 20 7716 8257
Within shadow banking, we watch the repo market more closely than any other it was repo that led
to the failure of Lehman, Bear Stearns and MF. In the US alone, the repo market is approximately
US$4.6 trillion the majority of which is overnight.
It was described as the silently beating heart of the market by the US Treasury and Advisory Committee. It is the nexus for collateralised lending, wholesale funding, leverage and short-selling on the
part of banks, institutional investors, money market funds and hedge funds.
Its worth emphasising for non-credit/money market investors that this market.
Is at the heart of the financial plumbing;
It is systemically critical to the functioning of the banking system and securities markets;
It was central to market failure in the 2008 crisis; and
The majority of the US$4.6 trillion of funding is of the SHORTEST POSSIBLE DURATION, i.e. overnight, and this aspect is clearly insane and should be dismantled.
It has not been reformed despite the Feds tacit understanding of the risks (see below).
In the repo market, collateral (e.g. Treasury and MBS securities) behaves like high-powered currency.
The middle of 2014 marked the start of a trend of more frequent spikes in Treasury Fails-to-Deliver in
the repo market.

Paul Mylchreest
Tel: +44 20 7716 8257
This is something we take seriously given repo fails indicate collateral shortage, which is akin to blockages in the pipes.
The major contributor to this latest round of collateral shortages is actually the Federal Reserve. It is an
unintended consequence of the QE programmes which silo vast amounts of high quality (e.g.
Treasury and MBS) collateral on the Feds balance sheet. This severely damages the availability of these
securities for repo purposes and, therefore, liquidity in the repo market.
Few people realise that we would almost certainly have had a crisis in the repo market already probably beginning in 2Q 2014 - if it hadnt been for the Fed rapidly stepping up its Overnight Reverse Repo
programme (ON RRP). This began piloting in very small size in September 2013 and is currently capped
at US$300bn.
The main reason given for the ON RRP was that it would be critical for exiting ZIRP - but that was only
half of the story. The ON RRP was also needed to supply high quality collateral silo-ed by the Federal
Reserves QE back to the repo market. As the chart below shows, this has even exceeded the US$300bn
cap at times.
Bill Dudley of the FRBNY acknowledged its role in addressing the collateral shortage when he stated
that the ON RRP would also,
increase the availability of a risk-free asset, satisfying the demand when the appetite for safe assets
increases.
The next chart shows that the trend in overnight repo rates since September 2012 (QE3 announcement) using a 20-day moving average - on Treasury collateral have been steadily rising since February
2014 (which coincided with the original devaluation of the Yuan).

Paul Mylchreest
Tel: +44 20 7716 8257
Without the smoothing effect of the 20-day M.A., you can see how volatility in repo rates has increased
markedly since late-2014. In our opinion, this is suggestive of increasing stress being felt in the
plumbing.

Paul Mylchreest
Tel: +44 20 7716 8257
The Fed knows understands the risk in the repo market. Indeed, Janet Yellen specifically identified it in
a speech, Regulatory Landscapes: A US Perspective, on 2 June 2013 (with our emphasis).
A major source of unaddressed risk emanates from the large volume of short-term securities financing transactions - repos, reverse repos, securities borrowing and lending transactions, and margin
loansengaged in by broker-dealers, money market funds, hedge funds, and other shadow banks.
Regulatory reform mostly passed over these transactions, I suspect, because securities financing
transactions appear safe from a micro-prudential perspective. But securities financing transactions,
particularly large matched books of securities financing transactions, create sizable macro-prudential
risks, including large negative externalities from dealer defaults and from asset fire sales. The existing bank and broker-dealer regulatory regimes have not been designed to materially mitigate
these systemic risks.
She said that more than two years agoand nearly five years after Lehmanand the much-needed reform has not been undertaken.
There was another warning sign last October. On 15 October 2014, we had the flash crash in US
Treasury yields. 10-year Treasury yields fell an incredible 34bp and rebounded a similar magnitude in
what was described as a seven standard deviation move.
With so many investors positioned on the short side for a Treasury sell-off and broker-dealers in
balance sheet contraction mode, the sudden spike in prices led to a rapid withdrawal of liquidity in the
worlds most liquid bond market. In his November 2014 essay, October Treasury Crash Shines a Light
on a Witless Fed, Jeff Snider of Alhambra Investment Partners noted that.
It may sound strange, but a buying panic in US Treasury bonds is a form of illiquidity. The modern
shadow system has in many ways inverted or at least distorted what could fairly be called currency
or a dollar. As I have said on many occasions, repo collateral is in many ways moneylike in its behavior and properties. At times, collateral becomes far dearer than actual currency, or even ledger
balances of currency, and thus behaves more moneylike. Such derivative function makes
straightforward analysis extremely difficult, especially to the outside.
This was a stark illustration of the diminishing liquidity across bond markets.
Moving into early 2015, we had the surprising (shocking for many) announcement from the Swiss National Bank (SNB) on 15 January 2015 when it abandoned its 1.20 peg against the Euro.

Paul Mylchreest
Tel: +44 20 7716 8257
The SNB specifically mentioned central bank policy divergence and dollar strength in its statement explaining why it was ending the Euro peg.
Recently, divergences between the monetary policies of the major currency areas have increased
significantly a trend that is likely to become even more pronounced. The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US
dollar.
In recent days weve seen the PBOC devalue the Yuan, which is directly related to dollar pressures (see
below).

Paul Mylchreest
Tel: +44 20 7716 8257
Eurodollar liquidity shortage becomes more apparent

Dollars, dollars everywhere but
Its hard not to reflect on the irony that the Fed could create an additional US$4.0 trillion on its balance
sheet alone and the world experience a growing shortage of dollar liquidity. At times, it seems that its
the flow that counts far more than the stock.
Cross-currency basis swaps are used by banks to convert liabilities in one currency into another currency. For example, the more negative the Euro/US dollar 5-year Basis Swap, the stronger the desire on
the part of banks to swap Euro liabilities (i.e. Euro deposits which they are absolutely drowning in,
thanks to ECB QE) into US dollar liabilities.
This is from the New York Feds paper Central Bank Dollar Swap Lines and Overseas Dollar Funding
Costs.
One metric used to measure funding stress in foreign exchange markets is the foreign exchange
swap basis. To arrive at this metric, analysts take an implied measure of dollar funding from a foreign
exchange swap using the uncovered interest rate parity formula and compare it with Libor. A foreign
exchange swap is a contract combining an FX spot and forward transaction and whose price, according to the uncovered interest rate parity, is derived from the differential between interest rates in
the domestic currency and the foreign currency.
The second quarter of 2014 (here we go again) marked the peak in the Euro/US dollar 5-year basis
swap, which has subsequently moved (and remained) well into negative territory as seen in this chart.

Paul Mylchreest
Tel: +44 20 7716 8257
The basis swap has correlated closely with the Euro spot rate.
Its noticeable how sharply the Euro/US dollar swap declined during January to March 2015.
By mid-March 2015, the upward pressure on the dollar was such that we cant help wondering whether
this was a factor in the Fed signalling a more dovish approach to tightening at the 18 March 2015 FOMC
meeting.
With the Yen/US dollar basis swap, there was a very sharp decline towards the end of 2014 - slightly
earlier than we saw in the Euro/US dollar.

Paul Mylchreest
Tel: +44 20 7716 8257
The correlation with the Yen has been relatively good since mid-2014, although the basis swap is currently indicating around 125.
There are private sector dollar swaps and there are official ones coordinated by the Federal Reserve
with other central banks.
The dollar swap facilities set up during the crisis were only meant to be temporary. Notwithstanding
this, they were made permanent standing arrangements on 31 October 2013. The six central banks involved are Federal Reserve, ECB, Bank of Japan, Bank of England, SNB and Bank of Canada.
There are no EM central banks in that list, obviously.
The PBoC, in particular, is a glaring omission for an efficiently functioning financial system based on
the dollar/Eurodollar.
Before we address the problems faced by the PBOC, it seems that the Fed has extended a new round of
dollar swaps to foreign central banks (most likely to one or more of the six named above) in order to
counteract tightness in Eurodollar liquidity. These dollar swaps are in the form of reverse repos. On its
website, the Fed describes the repo nature of dollar swap lines.
In general, these swaps involve two transactions. When a foreign central bank draws on its swap line
with the Federal Reserve, the foreign central bank sells a specified amount of its currency to the Federal Reserve in exchange for dollars at the prevailing market exchange rateAt the same time, the
Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction
that obligates the foreign central bank to buy back its currency on a specified future date at the same
exchange rate. The second transaction unwinds the first.

Paul Mylchreest
Tel: +44 20 7716 8257
These transactions are detailed in the line Reverse repurchase agreements Foreign official and international accounts on its balance sheet. While the recent spike seems to have gone unnoticed, here is
the chart since 2008.
Its fairly clear that the spikes have occurred at the time of stress in Eurodollar liquidity. Besides the
current episode, there was late 2008 (obviously) and 2010-11 with the Eurozone debt crisis.
The next chart shows how the volume of Fed reverse repos with foreign central banks has increased
sharply at times when the cost of Euro/US dollar swaps has spiked (the latter is inverted in the chart).

Paul Mylchreest
Tel: +44 20 7716 8257
Its worth remembering that, in general, dollar swaps undertaken by the Fed only need to kick in
when there is insufficient liquidity AND pricing is prohibitive in the FX swap market. The recent surge
makes perfect sense as currency basis swaps for any parties which needed dollars became much more
expensive at the end of 2014/beginning of 2015.
Is the BoE part of this?
We cant prove it, but it seems that the BoE has been involved in the current expansion of dollar swaps,
helping to backstop banks (probably UK banks) in the Eurodollar market.
On 30 June 2014and you cant get more mid-2014the BoE published a statement, Changes to the
Banks weekly reporting regime in which it explained that it would stop publishing key elements of its
balance sheet (like its SIZE) from the end of September 2014.
You only need to read the first line in the statement
A core function of a central bank is to provide liquidity insurance to the financial sector.
to know that the reason was to hide any measures to provide liquidity to the banking system. Indeed,
it goes on to acknowledge that.
Experience suggests that it is more effective for such operations to remain covert at the time, so as
not to further undermine confidence in the institution receiving support.
Because the publication of the full balance sheet
allows observers to identify the presence of liquidity support operations
Exactly. After waffling about the trade-off between the need to be transparent and open and seeking to
maintain financial stability (by doing the exact opposite which leads to the under-pricing of risk), the
BoE discusses how in the new publication.
the main omissions will be the overall size of the Banks balance sheet and other assets and other
liabilities.
And in particular.
omit data relating to bilateral operations.
Which obviously includes FX swaps. Regarding the omitted data.
which have the scope to inadvertently reveal the provision of covert liquidity support. Those items
will be reported on a quarterly basis but with a five-quarter lag.
On 5 November 2014interesting because we think Eurodollar liquidity was getting very tight at the
timethe BoE issued a statement on US dollar Repo Operations.

Paul Mylchreest
Tel: +44 20 7716 8257
The Bank of England will, on a regular basis, assess the need for US dollar liquidity-providing operations. It will take into account the fact that standing swap lines have created a framework for the
provision of US dollar liquidity to counterparties, if warranted by market conditions. All USD Repo
Operations will be unlimited fixed rate SMF (Sterling Monetary Framework) Advances.
If it looks like a duck (provision of dollar liquidity), walks like a ducketc.
Sowe have the Fed increasing dollar swaps and the BoE almost certainly a recipient on a covert basis.
Which UK banks have quietly asked for assistance? It might be those with major EM/Asia exposure Standard Chartered and HSBC would be potential candidates.
With the Fed ramping up dollar swaps to DM central banks, almost certainly including the Bank of England, EM banking systems look especially vulnerable since.
They have accounted for the vast proportion of the increase in offshore (Eurodollar) debt since
the last crisis; and
They have no dollar swap arrangements with the Federal Reserve.
With no dollar swap arrangements with the Fed, they are reliant on using foreign exchange reserves
to shore up their banking and shadow banking systems.
China is the major player here.
The point we are trying to emphasise is that, in our opinion, selling foreign exchange reserves is less
about stabilising their currencies and much more about the provision of dollar liquidity.
The peak in world foreign exchange reserves just happens to have occurred in mid-2014 (of course)
which obviously corresponded with the low in the dollar before its big move up.

Paul Mylchreest
Tel: +44 20 7716 8257
The background to the run on (Euro) dollar liquidity is dollar debt and the substantial proportion of
the global inventory of dollar debt held offshore in Eurodollar accounts.
The build-up of offshore dollar debt since the 2008 crisis has been dramatic. The BIS estimated a level
of US$9.46 trillion by the middle of 2014. This low-balls the actual number since it excludes dollar debt
of banks themselves.
Source: BIS

Paul Mylchreest
Tel: +44 20 7716 8257
In effect, the rest of the world is now running a short in the USdollar which is well over US$10 trillion.
When the offshore inventory (US$10.0 trillion +) is so large, there is a transmission of US monetary
policy to the rest of the world as McCauley, McGuire and Sushko of the BIS outlined in Global dollar
credit: links to US monetary policy and leverage (January 2015).
the scale of dollar borrowing outside the US means that US monetary policy is transmitted directly
to the rest of the world in several ways. Changes in the short-term policy rate are promptly reflected
in the cost ofUS dollar bank loansIn addition, unconventional monetary policy that reduces returns on Treasury bonds has also led bond investors to step up their extension of dollar credit to
bond issuers outside the US and lowered dollar bond coupons for non-US issuers.
The bigger the inventory of dollar debt, the more rapid and devastating the transmission mechanism
which is why we are arguing that the dollar is increasingly acting like a quasi global Fed Funds rate.
In a BIS paper from 2014, Cross-border banking and global liquidity, Bruno and Shin concluded that.
One prediction of our model is that episodes of appreciation of the US dollar are associated with
deleveraging of global banks and an overall tightening of global financial conditions.
Exactly.
The overall dollar debt has increased by approximately US$4.0 trillion - about 70% - since the end of
2008. The annual rate of offshore dollar debt growth has generally been in the 8-16% p.a. range since
2010, way ahead of domestic (non-Federal) dollar debt. Here is a BIS chart showing the increase to
June 2014.
Source: BIS

Paul Mylchreest
Tel: +44 20 7716 8257
Whats driven such rapid growth?

Empirical studies have shown that offshore dollar debt grows when dollar interest rates (LIBOR) are
below domestic rates and local currencies are appreciating versus the dollar especially if they are
considered to be a one way bet.
After the crisis, excessively easy credit conditions in the major DM nations, especially the US, were
transmitted across borders into other parts of the world via leveraging of banking and shadow banking systems.
In their paper,Transmitting global liquidity to East Asia: policy rates, bond yields, currencies and dollar credit, Dong He and Robert N. McCauley argue that suppressed interest rates in major developed
economies led to excessive monetary accommodation in other countries, China, Hong Kong and Korea
in this case.
low interest rates in major currencies make for immediately easier financial conditions where
there is a substantial stock of foreign currency credit
But it works both ways, obviously, and there is significant risk from the Feds tightening bias.
As the next chart shows, the build-up in this offshore dollar debt since Lehman has been dominated
by EM economies. EM accounts for more than US$3.0 trillion excluding an undisclosed share held in
Offshore centres.
Source: BIS
The EM economies and EM asset prices are clearly at risk from a further tightening in Eurodollar
liquidity and the need to counter with the sale of foreign exchange reserves.

Paul Mylchreest
Tel: +44 20 7716 8257
Within the inventory of offshore dollar debt, bank lending continues to account for more than 50% of
the total. In a simplistic view of the topology, the global banks tap pools of dollars in major financial
centres, both retail (e.g. deposits) and wholesale (e.g. money market funds and corporate deposits).
The global banks finance cross-border lending of dollars to regional banks which, in turn, lend to local
corporate borrowers.
Since the 2008 crisis, offshore dollar debt in the form of bond issuance has grown much more rapidly
than bank debt.
Source: BIS

Paul Mylchreest
Tel: +44 20 7716 8257
This gives portfolio managers a greater role in the transmission of US monetary policy overseas. Hyun
Song Shin of Princeton University refers to the acceleration in offshore dollar credit via bond issuance
rather than bank credit as the Second phase of global liquidity (the first phase being driven primarily
by bank lending in the run-up to the last crisis).
This is from McCauley, McGuire and Sushkos Global dollar credit: links to US monetary policy and leverage
The compression of bond term premia associated with the Federal Reserves bond buying has induced investors to bid for bonds of borrowers outside the US, many rated BBB and thus offering a
welcome spread over low-yielding US Treasury bonds. We also find that inflows into bond mutual
funds offering a spread over US Treasuries played a significant role in spurring offshore dollar bond
issuance. We interpret this as evidence of the portfolio rebalancing channel of the Federal Reserves
large-scale asset purchases.
While many of the EM issuers of dollar debt are either first-time issuers or have low credit ratings,
there is an additional risk. It also concerns us that some of these bond investors may be employing leverage.
The investment attitude of portfolio managers has become dramatically more important for EM corporate funding in recent years and this represents an additional pro-cyclical source of risk in aggregate.
Last year, Chui, Fender and Sushko of the BIS argued in Risks related to EME corporate balance
sheets: the role of leverage and currency mismatch that.
strong investor interest has underpinned EME corporate bond markets in recent years. If investors
were to suffer a significant loss of appetite, issuing firms might face difficulty in rolling over their outstanding debts, particularly if shifts in risk appetite coincide with a fall-off in projected earnings
Many of the recent EME corporate borrowers have gained access to the debt markets, both domestic and international, for the first time. The willingness of investors to let these issuers roll over their
debt in adverse circumstances is thus untested.
The value of domestic EM bonds has already collapsed not surprisingly given EM currency weakness

Paul Mylchreest
Tel: +44 20 7716 8257
and we are keeping a very close eye on EM dollar bond prices which look especially vulnerable right
now.

Paul Mylchreest
Tel: +44 20 7716 8257
Hyun Song Shin of Princeton University used the next slide in a presentation on The Second Phase of
Global Liquidity which highlights the spiral risk for EM.
Source: Princeton University

Paul Mylchreest
Tel: +44 20 7716 8257
China caught in the squeeze

China is the focal point of this squeeze in Eurodollar liquidity. Its financial system is a prime victim of
excess elasticity. This is the build-up of financial imbalances, including over expansion of credit, currency and maturity mismatches and dangerous expansion of shadow banking conduits.
The direct link between tightening dollar liquidity and monetary conditions in China was clearly illustrated with the taper tantrum of 22 May 2013, when Bernankes taper threat led to a spike in Chinas 7-day Repo rate...
...and a sharp decline in the Shanghai Composite.


Paul Mylchreest
Tel: +44 20 7716 8257
At the centre of this transmission mechanism is a large volume of dollar debt along with:
Currency mismatch - to an undisclosed degree;
Maturity mismatch a high proportion of loans might be based on short-term wholesale funding;
and
Commodity mismatch where dollar loans are collaterialised by commodity collateral,

e.g. copper.
By mid-2014, dollar debt to non-financial Chinese borrowers amounted to nearly US$1.1 trillion, having increased by about US$900bn since the crisis see the centre pane in the BIS charts below.
Source: BIS
However, we think Chinese dollar debt exceeds this level significantly as it excludes US$600bn-1.1 trillion (depending on the definition) held in Hong Kong, part of which is attributable to Chinese borrowers (we show the topology of some of these loans below).
In some cases, dollar borrowings might be largely/partially hedged by dollar receivables. While its impossible to calculate the extent to which intentional currency mismatches were created on corporate
Chinese balance sheets, we think that it is widespread.
Why would so many Chinese borrowers deliberately run a substantial currency mismatch? Because it
seemed like a cast-iron way to make money for many years.
Besides the arbitrage on interest rates, a currency mismatch can seem very attractive if local borrowers
believe that the local currency will continue to strengthen versus the dollar especially if it is perceived as a one-way bet. This was precisely the problem with the Yuan, which was viewed as a oneway bet for many years. This is from the BISs He and McCauley paper.
to the extent that domestic currencies are expected to appreciate against major foreign currencies,
currency expectations reinforce interest rate differentials in encouraging firms to borrow in foreign
currency.

Paul Mylchreest
Tel: +44 20 7716 8257
Indeed, for many years China was branded as a currency manipulator by the US for keeping the value
of its currency too strong.
Following the recent devaluation of the Yuan, a Bloomberg story on 27 August 2015 commented.
The yuans devaluation is a wakeup call for Chinese companies that rarely hedge overseas debts
Chinas second biggest steelmaker Baosteel Group Corp, its largest auto rental company Car Inc. and
developer Country Garden Holdings Co. said theyre considering hedging after the Aug. 11 devaluation.
This leads us on to the subject of carry trades.
The magnitude of the dollar/Yuan carry trade is unknown, but market estimates have put it in the
US$500bn to US$1.0 trillion, or even higher. This was a comment by the FT.
The perception that the renminbi could only strengthen fueled the so-called carry trade of borrowing US dollars cheaply offshore and then cycling them into China for the higher interest rates and
currency appreciation. That in turn led to wildly inflated trade data as Chinese companies used fake
invoicing as a means to bring money onshore.
Below is the topology of a Chinese corporate borrowing dollars from Hong Kong, using Yuan deposits
as collateral, with dollars provided either from a parent bank or the wholesale funding market.

Paul Mylchreest
Tel: +44 20 7716 8257
Source: BIS
In the scenario above, non-bank corporates effectively became financial intermediaries in stoking the
credit bubble. From Chui et al.
To the extent that non-financial corporates issue debt but hold the proceeds as liquid claims, they
behave as surrogate intermediaries channelling funding from global capital markets into the domestic financial system
This should raise an immediate red flag.
In this example, the funding is likely to be short-term and raised in wholesale dollar money markets.
There is another risk. If local borrowers are holding large deposits in local banks and are merely playing
the carry trade, they could be forced to withdraw these deposits if they are squeezed on the currency.
This could, in turn, put stress on wholesale funding in the local banking system.

Paul Mylchreest
Tel: +44 20 7716 8257
Its possible that the extreme volatility in Overnight HIBOR the Hong Kong Inter-bank Offered Rate
is reflecting this stress.
On the subject of Yuan/dollar carry trades, there is the shadow banking conduit where dollar loans are
collateralised by imports of copper (and other commodities) held in bonded warehouses. The close relationship between the rise in the trade-weighted value of the dollar (inverted in the chart below) and
the fall in the copper price since mid-2014 suggests that these trades are being unwound.

Paul Mylchreest
Tel: +44 20 7716 8257
It also establishes a link between tighter dollar liquidity and the copper price and is more evidence
that links between US monetary policy, dollar liquidity and the Chinese economy are broad/
complex.
Besides the plain vanilla balance sheet dollar short and the commodity-backed shadow dollar short,
Jeff Schneider of Alhambra Partners writing (prophetically) in March 2014 makes the case for a transactional short related to.
Chinese companies that export to the US (e.g. Foxconn) are not the same companies that import
resources for all that manufacturing and assembling. The exporters gain a surplus of dollars, but
have to turn them over (through Chinese banks) in large part to the PBOC (Chinas central bank) to
maintain that peg. Importers in turn have to obtain dollars to purchase materials on the global markets because there is, as yet, no depth in yuan trading outside narrow, bespoke bilateral arrangements
Schneider continued.
That means that the Chinese corporate sector is short dollars to conduct global trade. Exporters
had a surplus but gave it up to the PBOC, and importers have to borrow dollars from either foreign
banks onshore or native Chinese banks that themselves have to borrow dollars. Somewhere in that
dollar chain lays Eurodollar market rollovers. That links US dollar tightening to Chinese liquidity.
Once again, this emphasises a key issue which is the need to fund and roll over Chinas dollar short in
wholesale funding markets.
As the shortage of Eurodollar liquidity has intensified, this has become more problematic.
This issue is being hindered by capital outflows from China which began last year. Capital flows as
measured by China Balance of FX Settled and Sold by Banks, turned negative in Q3 of 2014.


Paul Mylchreest
Tel: +44 20 7716 8257
We showed above how world forex reserves peaked in mid-2014, coinciding with the start of the dollars upward move and breakout of the 30-year wedge. A similar thing happened with China just
slightly earlier in 2014.
That fits, once again, with the initial impact of the Eurodollar shortage impacting China in the early part
of 2014.

Paul Mylchreest
Tel: +44 20 7716 8257
We believe that the primary reason for Chinas sale of forex reserves and US Treasuries sales
(reportedly US$100bn+) has not been to support the Yuan, but to provide wholesale Eurodollars to
its banking system.
When the Fed raises rates, its fair to say that the rest of the world faces a more serious risk than ever
before, especially China. Here is Borio and McCauley from the BIS in Transmitting global liquidity to
East Asia (with our emphasis).
The transmission of global liquidity to Asian economies needs to be understood and taken into account by policy-makers in the region and in the key currency countries. It is worth recalling that the
deflationary shock from the currency depreciations during the Asian financial crisis in 199798 interrupted the tightening phase of the Federal Reserve, with implications for asset markets. The already
difficult exit from very accommodative policy over the next several years would only be more challenging in the event of financial instability in East AsiaIn other words, if no account is taken of spillovers, there is a risk of instability with blow-back effects to major economies.
An exit from ZIRP is complicated by the fundamental change to the mechanics of implementing a rate
increase now that the formerly used Fed Funds mechanism is no longer effective. Furthermore, the
proposed new mechanism is much more deeply integrated into the shadow banking system.

Paul Mylchreest
Tel: +44 20 7716 8257
Fed policy now complicated by shadow banking

The implementation of Fed policy going forward is going to be far more complex than it has been historically. Not only has the traditional Fed Funds mechanism been rendered irrelevant by QE but the
knock-on effect of Fed policy on the rest of the world is so much greater and stresses in the plumbing
could be exacerbated.
This is a risky environment for the Federal Reserve to propose to raising rates, albeit from a very low
level. In addition, further complicating matters (potentially), US banks currently play a minor role in
dollar credit markets outside the US and a reduced role in domestic wholesale money markets vis--vis
US branches of foreign banks.
Changing Fed interest rate policy going forward is no longer just a simple case of the Federal Reserve
establishing a higher interest rate in the Fed Funds market. The Feds QE programmes broke the Federal Reserves traditional monetary transmission mechanism by all but killing off the Fed Funds
(bank reserves) market. The Fed Funds market has dwindled to about US$50bn, having been US$250300bn in the past.
In those days, the Fed ensured that there was tension in the market for banks reserves, then it instigated QE and the banking system became awash with (currently) just over 2.5 trillion of excess reserves.

Paul Mylchreest
Tel: +44 20 7716 8257
As Simon Potter, head of the FRBNYs markets desk, noted in a speech on 15 April 2015, the volume of
excess reserves is at
a level at which the Open Markets Trading Desk (the Desk) will be unable to move the effective federal funds rate up or down with small variations in the supply of reserves, as it did before the financial crisis.
Weirdly, when the Fed adjusts rates in future it will (still) target an interest rate (Fed Funds) for a
market which is far smaller and far less relevant than ever before. This is supposed to help people
who dont understand whats going on or how money markets have changed.
The flexibility to move Fed Funds to a desired rate in the new environment was the cue to devise a
new transmission system, which is basically an interest rate corridor.
The ceiling of the corridor, which is expected to be 25 bp wide, will be IOER which will be set according
to the top of the target range for the Federal Funds rate. However IOER is only available to banks. The
FRBNYs William Dudley commented in a speech The US Economic and Monetary Policy Outlook on 5
June 2015.
Most importantly, we have demonstrated that the interest rate paid on banks reserve balances
(IOER)which is our primary tool to raise the federal funds rate targetand daily overnight reverse
repo (ON RRP) operationswhich is a supplementary tool to help put a floor under money market
rates
In our opinion, IOER is not the primary tool at least not until bank reserves become somewhat
scarce, which is a distant prospect.

Paul Mylchreest
Tel: +44 20 7716 8257
Instead the primary tool will be the Feds ON RRP, which was first introduced on a pilot basis in December 2013. Currently it pays 5 basis points and is limited to US$30bn per counterparty and a total volume of US$300bn (and averaging US$120bn during the last 12 months).
The aim of the ON RRP is to set the floor of the rate corridor and to lead other rates in US money markets.
The potential difficulty arises with a Fed liftoff when, in order to be effective, the Fed has to include a sufficiently broad set of non-bank financial institutions in the money markets. Eligible ON
RRP counterparties include banks, GSEs, Federal Home Loan Banks and money market funds (MMFs)
and, consequently, a potential volume of funds which amounts to many US$ trillions. Its also uncertain how much support is currently being provided by having interest rates so close to the zero
bound at present, something which would be lost on liftoff.
The Fed has (at least) three problems.
How big does any cap on the ON RRP need to be or should it be unlimited (full allotment)?
If its not big enough when the Fed raises rates by (say) 25bp, many money market and shadow
banking rates might fail to fully follow the Feds lead, e.g. only rising by 5-10bp.
Will the Feds ON RRP facility be so attractive that it crowds out other borrowers in the money
and shadow banking markets?
Not surprisingly, the Fed has been thinking about these issues as has been clear from FOMC minutes.
This was from the 17-18 March 2015 meeting, for example.
A staff briefing provided background on options for setting the aggregate capacity of the ON RRP
facility in the early stages of the normalization process. Two options were discussed: initially setting
a temporarily elevated aggregate cap or suspending the aggregate cap for a time.
This is an extremely difficult judgement for the Fedone which is impossible to know the answer
ahead of timeand which could be impacted by changing financial conditions.
A key question is
Why wouldnt the money market fund (MMF) industry and other non-bank financial institutions invest a substantial amount (or most) of their funds with the Feds RRP?
The counterparty risk with the Fed is theoretically zero and most MMFs are not in the business of
reaching for yield even if alternative investments offer marginally higher yields. The Fed doesnt
want to take the majority of the money markets on its balance sheet.

Paul Mylchreest
Tel: +44 20 7716 8257
So, while paranoid about being big enough the Fed is equally concerned about a
full allotment approach, which could also have undesirable effects. The Fed, via Potter in his 15 April
2015 speech, is talking confidently - full allotment is not necessary in his view.
Through testing, we've learned that the fixed-rate and full-allotment features are not necessary for
securing interest rate control. Moreover, by supplying a perfectly elastic quantity of a risk-free asset
at a fixed-rate, a fixed-rate, full-allotment ON RRP facility might have undesirable effects on financial
stability
Maybebut it might have to be very big still.
For example, the total value of MMFs is still over US$2.5 trillion, even if its well down on 2008 levels.
Under the current programme, the Fed executes ON RRPs with MMFs accounting for about 70% of the
total.
In a liftoff scenario, what volume of MMF assets might the ON RRP attractUS$0.5 trillion, US$1.0
trillion, US$1.5 trillion? Who knows!
So the Fed probably has to go big at firstbut this could have unintended consequences.
What if the Fed crowds out other participants in the money markets?
Who will buy many of the short-term credit instruments that need funding? For example, Commercial
Paper issued by banks and large corporate borrowers, bank CDs and short-term Agency debt.

Paul Mylchreest
Tel: +44 20 7716 8257
The Commercial Paper market, for example, has also shrunk in size since the 2007-08 crisis, but is still
in excess of US$1.0 trillion.
MMFs account for about 50% of lending to CP borrowers, making this sector particularly vulnerable if
MMFs substantially increase their Fed RRP activity. A funding crisis in the CP market is possible and the
average maturity is only several days.
Ironically, the last time there was a funding crisis in CP (post-Lehman), the Fed needed to create a facility using its balance sheet to lend to banks so that they could purchase (AB)CP from MMFs. While this
was partly to allow MMFs to meet redemption requests, it also allowed CP issuers to roll maturing paper.
Its also unclear to what extent money market rates are currently being supported from being so close
to zero. As Potter highlights.
Importantly, we will likely not know the level of support that proximity to the zero lower bound has
provided to money market rates until we start to move away from it. Demand for ON RRPs following
liftoff could remain relatively steady. But it could conceivably be much greater than what we have
seen at higher levels of interest rates or as regulatory and structural changes in money markets
boost demand for safe assets
Another problem for the Fed is that the ON RRP could become super attractive to participants in
wholesale money markets during periods of financial turbulence. Even Potter acknowledges this.

Paul Mylchreest
Tel: +44 20 7716 8257
In periods of financial stress, the availability of a fixed-rate, full-allotment facility could enable a
rapid or unexpected expansion that exacerbates disruptive flight-to-quality flows by facilitating a run
away from funding financial institutions and nonfinancial corporations. This dynamic could undermine financial stability.
Exactly. And if its not full allotment at the time (or the cap is not set at a very high level), rates will
probably crash to zero and the Fed would lose control.
Liftoff is going to be a challenge for the Fed and its an uncertainty which is not well understood by
many investors. The Fed has emphasized that the ON RRP is only meant to be temporary but it looks
like it might need to be in place for a prolonged period of time in our opinion.
Furthermore
We already have a dollar liquidity issue which seems to be focused in offshore (Euro) dollar markets.
Tightening monetary policy via the ON RRP risks catalyzing destabilizing capital flows in a financialised global economy.

Paul Mylchreest
Tel: +44 20 7716 8257
Financialism and defensive stance on Equities

There is no agreed definition of financialism, but the general principle is the vastly increased role of
finance during the last 30-40 years at the expense of the real economy.
This was Lawrence E. Mitchell writing about the US economy in his book The Embedded Firm.
Unfortunately we have more sympathy with his view than wed like.
It has created a new economic system that appears to be capitalist but no longer performs the functions of capitalism. Capitalism is a system in which wealth is created and sustained by the production
of goods and services determined through market supply and demand. A variety of related structures support capitalism, including the institutions of finance, which provide the funds necessary for
the production and trade of goods and services. While capitalism still characterizes a portion of the
American economy, it has become subordinated to a new economic orderThis new economic system is Financialism.
While we have focused on excessive credit creation and the volume of global speculative capital, financialism comes in many guises.
The power of financial markets and speculative capital within;
Reliance on central banks to rescue TBTF financial institutions and support financial markets at
critical moments;
Unhealthy influence of major investment and commercial banks;
The stock of globally traded financial assets has increased from US$7 trillion in 1980 to something approaching US$200 trillion.
Securitisation of just about any financial obligation;
Financially-driven transactions, e.g. share buybacks;
High frequency and algorithmic trading methods;
Financial performance targeting;
Personnel involved in financial services (including compliance); and
Innovation in financial instruments, especially in derivatives (claims on claims on claims which

become ever more removed from what most people would view as reality).
Central banks are important facilitators of financialism via ZIRP policies, credit creation and intervention/subversion of free markets.

Paul Mylchreest
Tel: +44 20 7716 8257
Surges/reversals in speculative capital are never taken into account by static economic models. Under
the right conditions, speculative capital flows can overwhelm almost anything in their path.
As we undertook our research, we found that the BIS had grasped the idea of financialism, even if it
didnt use the term. In August 2014, Claudio Borio of the BIS argued that.
the Achilles heel of the international monetary and financial system is that it amplifies the excess
financial elasticity of domestic policy regimes, i.e. it exacerbates their inability to prevent the buildup of financial imbalances, or outsize financial cycles, that lead to serious financial crises and macroeconomic dislocations.
The chart below neatly illustrates the general message regarding the rising tide of financialism.
Source: BIS
In a 2014 paper by Claudio Borio (again) and Hyun Song Shin, The International Monetary and Financial System: A Capital Account Historical Perspective, they argued.
in a highly globalised economy financial markets hold sway
We couldnt agree more.

Paul Mylchreest
Tel: +44 20 7716 8257
With regard to the equity market, we had searched (as per previous reports) for technical indicators
which gave well-timed sell signals on the S&P 500 at the last two bull market peaks in March 2000
and October 2007.
In March 2015, we highlighted what we found to have been the best one, which we referred to as
the Adjusted MACD Indicator. MACD stands for Moving Average Convergence/Divergence. It
consists of three time series.
MACD series;
the signal or average series; and
the divergence between the two.
From Wikipedia.
The MACD series is the difference between a fast (short period) exponential moving average
(EMA) and a slow (longer period) EMA of the price series. The average series is an EMA of the
MACD series itself. The MACD indicator thus depends on three time parameters, namely the
time constants of the three EMAs. The notation MACD(a,b,c) usually denotes the indicator
where the MACD series is the difference of EMAs with characteristic times a and b, and the average series is an EMA of the MACD series with characteristic time c. These parameters are usually
measured in days. The most commonly used values are 12, 26, and 9 days, that is, MACD
(12,26,9).
Please also note that an EMA uses exponentially decreasing weights to older data points in a time
series.
While the MACD is normally calculated on EMAs of 12, 26 and 9 days, we noted that the best indication for predicting the last two peaks in the equity market was 25, 26 and 9 days. Based on further work, we have established that the best combination is based on EMAs of 25, 26 and 6 days.
This gave sell signals on the S&P 500 in February 2000, i.e. one month before the 2000 peak, and
December 2007, that is two months after the 2007 peak.
At end-June 2015, we saw the first month-end crossover from positive to negative in the Adjusted
MACD since December 2007.

Paul Mylchreest
Tel: +44 20 7716 8257
Below is the current monthly adjusted MACD chart for the S&P 500 since 1998. You can see in the
chart that the white line in the lower pane has crossed below the red line. This results in a negative
value for the relevant green bar which measures the difference between the white and red lines.
Source: Bloomberg
The S&P 500 made a closing high in the current bull market on 21 May 2015 at 2,130.8 and almost
reached this level again, when it closed at 2128.3. Our cautious stance towards equities highlighted in
the 6 July 2015 report S&P500: technical indicator which called the 2000 & 2007 peaks gives first sell
signal for current bull market in Equities remains in place as does our preference for defensive positioning in sectors and stocks.

Paul Mylchreest
Tel: +44 20 7716 8257
It is beyond the scope of the current report, but sectors which could be at risk include (rather obviously) Banks where any escalation of problems in the plumbing are not priced in.
Here is the US Banks sector (BKX) relative to the S&P 500 since 2012.
And the Euro Stoxx Banks sector relative to the Euro Stoxx 50 index.

Paul Mylchreest
Tel: +44 20 7716 8257
We would also highlight.
Capital Goods structural weakness in global capital investment cycle and risks to long-term investment horizons;
Autos rapid slowdown in China and unsustainable level of US production driven by cheap (subprime) financing and inventory build.

Paul Mylchreest
Tel: +44 20 7716 8257
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Do Central Banks Need A Plumber?

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Equity & Cross Asset Strategy

16th September 2015

Tel: +44 20 7716 8257