No where to hide as Fed liquidity evaporates

The Fed’s liquidity tide has turned, stranding a variety of private and public capital strategies. Not since the dot-com bubble has Warren Buffett’s aphorism about the falling tide revealing who’s been swimming naked been more appropriate.

On a broader level, the sudden lack of diversification and increased correlation between bonds and stocks has blown a hole in the core theory behind most pension fund models and significantly affected the real wealth of many pensioners. .

After years of average returns of 6 to 7 percent for 60:40 funds, they are down 10 to 15 percent to date. Meanwhile, as the RBA and other central banks follow the Fed in unison, the impact on ordinary household cash flows from higher mortgage rates is starting to weigh on the housing market.

To fix the inflation caused by their previous policies, they are now threatening stagflation. Everything is getting hit, with nowhere to hide except US dollar cash and perhaps very short term bonds.

May has also seen almost all currencies collapse against the dollar, including pseudo currencies like cryptocurrencies, and even gold. However, while the current US dollar strength is portrayed as a flight to quality and the last place to hide, we suspect this is temporary, even if true.

In fact, the dollar’s strength is much more likely to be part of a broader deleveraging game across asset classes. As the Federal Reserve shrinks its balance sheet, so do most financial players that run carry trades and leveraged positions in general. A sharp move in exchange rates (both the Australian dollar and the yen, for example, fell nearly 14 percent in one month) means a currency mismatch is devastating, forcing dollar loans to close.

Beyond this, however, there is an even bigger problem, that of a weaker dollar based on the recognition that, for most of the world, the dollar is no longer low risk.

In fact, for investors outside the US, there is arguably no longer even a common risk-free rate to base things on. The unprecedented move by the Biden administration to freeze and essentially seize the foreign assets of the Russian people has effectively destroyed the concept of the dollar and especially US Treasuries as a risk-free asset.

Simply put, an asset that can go to zero overnight can no longer be considered risk-free for anyone outside of the US in ‘The Rest’, this has significant implications for long-term capital flows. In fact, we don’t think it’s an exaggeration to say that this is the largest potential systemic shock to financial markets since Nixon took the dollar out of parity with gold in 1971.

What it also means is that anyone with assets in US dollars, but who is worried that their government may violate US foreign policy at some point in the future, will now look to move those dollars into “safer” assets. “out of the dollar. zone.

Indeed, it will be interesting to see how demand holds up for trophy properties in Sydney and Melbourne, not to mention London, Vancouver and San Francisco, now that they function as risk multiplication rather than risk diversification.

Having said that, with the dollar where it is, buying commodities or real assets outside of the US looks very attractive at the moment and we wouldn’t be surprised to see a rally in M&A throughout Asia-Pacific and emerging markets.

As for China, with $1 trillion in US Treasuries, it may choose not to sell, but it seems unlikely to be a buyer of many more, and indeed one angle could be to get a lot of liabilities. in dollars against those and use them. to buy real assets.

Perhaps China could borrow dollars against its Treasuries to pay for the next phase of One Belt, One Road? Who knows? Maybe they already have.

Mark Tinker is Chief Investment Officer of Toscafund Hong Kong and founder of Market Thinking. He blogs about behavioral finance and markets at Market-thinking.com.

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