Global FX, Libor and the Global USD Rout
The rising US LIBOR rate is putting additional selling pressure on the USD with additional catalysts coming from China where entities there are reducing USD loan exposure and the deflationary implications from RMB weakness. In particular, 3m USD LIBOR rates have increased dramatically from 62bp to 82bps caused by regulatory changes becoming effective on the 14 October. When China tightened monetary conditions in late 2013 trying to curb excessive domestic lending growth, China’s corporate sector replaced RMB loans with USD loans, where the USD loans accounted for over 10% of China’s GDP. The record rise of China’s FX reserve in Q1 2014 and the simultaneous RMB appreciation pressure has been linked to USD denominated borrowings and the subsequent swap of USD proceeds into RMB. Today, the WSJ reports that rising US LIBOR rates increasing corporate credit costs may convince foreign corporates to reduce their USD borrowings.
Just on its own this operation would increase USD demand and should lead to a higher USD. However, there are two other effects coming into play turning the USD outlook into a net negative. First, Japan’s MoF has reported increasing foreign demand for short-term JGB’s linking this demand to Chinese entities. Yesterday we reported falling Fed custody holdings (i.e. the treasuries held at the Fed on behalf of foreign FX reserve managers). Global currency reserves had been falling since autumn 2015 therefore the reduction in the custody holdings was something we would have expected. However, currency reserves are currently no longer falling, yet the decline of custody holdings has even accelerated from here suggesting reserve managers are reallocating reserves from USD’s into other currencies including the JPY, keeping the USD offered.
Secondly, rising USD LIBOR rates convincing Chinese corporates into reducing USD denominated debt exposures has the potential to push the RMB even lower from here. Consistent with this view is expectations that China’s capital outflows have accelerated in July. While the size of the outflow is still moderate compared to earlier this year reported flows a sizeable increase of outflows have become visible. The falling RMBdecreases import prices for China’s trading partners and the more developed the trade relationship, the bigger the impact of falling import prices is on local inflation rates. Once again, Japan comes to the forefront with its falling inflation rates pushing real rates up increasing the attractiveness of JPY denominated money market holdings. The recycling of Japanese rising current account surplus (3% of GDP) can only work with the help of a rising JPY.
Others conclude that China’s deflation pressures may ease citing the moderation of its producer prices deflation easing from -5.9% in January to -1.7% in July. For us it is interesting to separate the FX impact from underlying domestically generated price trends. China’s easing producer prices are due to rising input prices. Metal and energy prices have risen in RMB terms, while other components of PPI have remained deflationary. The lower RMB may ease some of China’s deflation pressures, but it does instead increase deflation pressures of China’s main trading partners. Asian currencies rallied sharply this morning, and for good reason. The faster the RMB declines the bigger the global deflationary implications, pushing high debt countries into balance sheet consolidation. National savings exceed local investment opportunities, first supporting local bond markets and secondly local equity markets as lower local bond yields allow for a higher equity market valuations.
The USD has further downside potential from here with the Fed’s Williams calling for a higher inflation target or the adoption of nominal GDP target by central banks in order to combat the impacts of lower natural interest rates. Williams added the U.S., “should be critically revaluated to identify potential improvements” in the context of a low natural interest rate. Moreover, the June treasury flow data showed net foreign purchases of long-term securities -$3.6b vs $40.8b in May and substantial outflows in bank deposits (-USD174bln).