EDLiq

Equity & Cross Asset Strategy
Commodity Prices & Inflation

Dollar Liquidity Threat is Getting Critical and Fed is M.I.A.
We know the narrative...Trump equals higher inflation, a tailwind for

commodities and a headwind for bonds. We are Endgame Inflationistas,
but declining US dollar liquidity threatens this narrative near-term.
Dollar illiquidity is something that even central banks struggle to control, e.g.
Swiss Franc peg, BoJ losing control of the Yen and now the PBoC/RMB.
The price of the dollar acts like a Global Fed Funds Rate. A rising dollar
tightens economic conditions globally, adding considerable deflationary
pressure as is clear from the chart below.
Most commentators are not making the link between a rising dollar and a
shortage of offshore dollars (Eurodollars). Chinas financial system is vulnerable and its being reflected in RMB weakness. The lack of a dollar swap
between the Fed/PBoC is a glaring omission. We expect BRICS nations to
become increasingly irritated about the current dollar-based system.
In his recent speech, Is There a Liquidity Problem Post-Crisis?, Fed Vice

Chairman, Stanley Fischer, concluded that liquidity is adequate. Sadly, that
is incorrect and a glance at the chart (see next page) of negative Cross
Currency Basis Swaps for dollar funding illustrates the error all too easily. A
US$10 trillion Eurodollar short is a more dangerous and risky beast if the
Fed doesnt understand it!
Dollar Index (Inverted) v. G7 Inflation (since 2006)
60.0
5.0
65.0
4.0
70.0
3.0
75.0
80.0
2.0
85.0
1.0
90.0
95.0
0.0
100.0
-1.0
105.0
Dollar Index (Inverted)
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
-2.0
2006
110.0
OECD G7 CPI (yoy %)
November 2016
Paul Mylchreest
Email: paul.mylchreest@admisi.com
Tel: +44 20 771 6257

Paul Mylchreest
Tel: +44 20 7716 8257
The table below shows the Cross Currency Basis Swap (CCBS) for US dollars using the average
for Euros, Yen, British Pounds, Swiss Francs and Canadian Dollars. We discuss the CCBS in more
detail below but, in essence, it is the additional cost of borrowing dollars via FX swaps in these
currencies compared with what it should be according to interest rate differentials. The more
negative the CCBS the more it implies a structural dollar shortage and a liquidity problem in
dollar funding markets.
Source: ADM ISI, Bloomberg
While the problem has been building for more than 2 years, mainstream economic luminaries
are (belatedly) starting to take notice. This was Harvards Carmen Reinhart last month.
Today, seven decades later, despite the broad global trend toward more flexibility in exchange-rate policy and freer movement of capital across national borders, a dollar shortage
has reemerged.
Maybe its because the dollar shortage is outside the US that western commentators have not
paid more attention so far.
Before we get into that, lets briefly outline the Big Picture framework that we use to put the
current situation in financial markets into a long-term context. Our framework is based on Long
Wave economic cycles and the reason for mentioning it is to highlight:
The sheer scale of the deflationary forces acting on the global economy which are exacerbated by dollar strength; and
The precarious balance between massive deflationary forces and opposing inflationary
forces.
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Paul Mylchreest
Tel: +44 20 7716 8257
Briefly, we are in the fourth Long Wave cycle since the Industrial Revolution. The timing and
duration of these cycles has been as follows.
Cycle
Estimated Timing
Length (years)
First
1788 -1843
56
Second
1844 - 1896
53
Third
1897 - 1933
37
1934 -
82
Fourth
Source: ADM ISI
Historically, these cycles have been characterised by specific trends in prices (inflation/
deflation), debt, GDP growth, interest rates and asset prices.
As a cycle evolves, there is a progressive shift over several decades from benign inflation to
high inflation followed by a rolling over into disinflation and, finally, the most difficult period
of deflation.
While these long wave fluctuations have primarily been defined by prices, the driving force behind them has always the accumulation of debt (or credit to use more gentile terminology).
As a cycle progresses, however, more and more of the incremental debt tends fuels asset bubbles instead of benefiting the real economy?
Sound familiar.
In the previous three cycles, debt eventually overwhelmed the system, leading to a busting of
the bubble, which heralded the onset of the final Winter phase.
In each case, the catalyst for the bursting of the bubble was a crash in the equity market:
Panic of 1825;
Panic of 1873; and
Crash of 1929
In each case, the response of central banks and governments was constrained by hard money system in stark contrast to today. The subsequent debt deflationary phases were of varying lengths and intensities prior to the emergence of a new Long Wave cycle.
During these payback phases, debt deflations purged the excesses in terms of debt, misallocated capital and asset bubbles.
3

Paul Mylchreest
Tel: +44 20 7716 8257
Besides clearing the decks, the deflationary phase of these cycles served in part to restore the
purchasing power of over-extended consumers/businesses as each cycle drew to a close.
However
This self-correcting ability of free markets is well beyond a modern central bankers understanding. To them, inflation in a globalised world suffering from widespread labour competition is a good thing. So is the creation of ever larger financial bubbles.
You just cant tell some people.
The current Long Wave cycle is the longest by far at 83 years (and counting) thanks to the
counter-inflationary ability of policy makers.
In 2000 and 2008, the magnitude of debt and misallocated capital firstly in the emerging internet/technology sector then US housing market - overwhelmed the financial system, leading
to market crashes and subsequent recessions.
The normal debt deflations were short-circuited.
On both occasions, central banks, in particular the Federal Reserve, used their almost unlimited flexibility in terms of monetary policy to, to re-inflate the US and global economies.
The result has been a series of credit/asset price bubbles where, so far, each bubble and subsequent bust has been bigger than the previous one.
4

Paul Mylchreest
Tel: +44 20 7716 8257
Re-inflating each burst bubble has required more extreme stimulus in terms of rate cutting
and credit creation
In the wake of the 2000 bust, Greenspan cut the Fed Funds rate from 6.5% to 1.0% and
left it there for a year. This was considered unprecedented and bordering on reckless at
the time (which seems darkly amusing now). Between the beginning of 1999 and the end
of 2003, the Feds balance sheet increased from c.US$550bn to just over US$770bn
about 40%; and
In the aftermath of the 2007-08 crisis, the Fed Funds rate was cut from 5.5% to 0% and
the Feds balance sheet expanded from c.US$870bn at the beginning of 2007 to over
US$4.5 trillion by the end of 2014 about 420%.
creating a new bubble larger than the prior one.

Its no surprise that central bankers choose to deny their own culpability.
But
Its harder to fathom why legions of economists and mainstream journalists would choose to
deny, or fail to see, something this obvious. On one hand, there are powerful vested interests,
e.g. strong ties to incorrect economic dogma and career risk from not siding with the consensus.
On the other hand, its the nature of bubbles.
Look at those beauties
5

Paul Mylchreest
Tel: +44 20 7716 8257
Since 2000, central banks have prevented a clearing of the decks and the creative destruction which could have heralded the beginning of a new Long Wave cycle.
Instead, they have used monetary policy to significantly extend and distort the last phase of
the current Long Wave cycle.
The global economy has been financialised. When sanity prevailed, financial markets were primarily a reflection and facilitator of the global economy. Now that its been financialised, we
have a sort of upside down casino in which financial markets act as the primary support
mechanism and tend to lead the economy.
When the global economy is excessively dependent on the financial system, the feedback loop
between loss of confidence in financial markets and the economy in general is obviously dramatically greater.
The result of a decade and a half of central planners saving the world and extending the cycle
is a minefield for investors as the battle between the forces of deflation and inflation only
intensifies.
The post-Trump election victory spike in bond yields on expectations of higher inflation from
fiscal stimulus being a case in point. From the low on 9 November 2016, the US 10-year Treasury yield rose 55bp in just over 3 days.
We never get tired of pointing out that as Janet/Mario/Haruhiko stretch the cyclical elastic,
the deflationary and inflationary forces are simultaneously becoming more powerful. This is
probably unappreciated because they are close enough to balance most of the time.
When, these forces move out of balance and one prevails, the necessary scale of structural adjustment will be that much greaterbut only when the day of reckoning arrives. In the meantime, an ECONOMIC WAR continues to playout:
Long Wave
v.
Central Banks
Deflation
v.
Inflation (or Re-inflation)
On one side, we have the Long Wave and obvious deflationary forces (excluding the dollar):
The global debt bubble;

Negative demographics in several major economies;
Overcapacity in some basic industries, e.g. steel, iron ore, coal, shipping, etc;
Globalisation; and
Technological advancenot just leading to lower costs but, in some cases, businesses
which are light on capital/labour, e.g. many social media and internet companies .
The pre-eminent deflationary force is the debt bubble.

6

Paul Mylchreest
Tel: +44 20 7716 8257
In Q2 2014, McKinsey estimated that global debt amounted to US$199 trillion, so we are now
well above $200 trillion.
Source: McKinsey
Debt has a time function. In essence, it brings forward consumption from the future into the
present. Consequently, it has a powerful, geared impact on economic growth when applied to
goods and services in the real economy.
Given its time function, debt effectively buys timethe problem being that the present eventually catches up with what was the future.
Socue unconventional monetary policies and centrally-planned credit creation by central
banks as theyve attempted to fix the unexpected (for themsince debt mountains do not form
part of their models) shortfalls in growth.
Source: IMF
The inflationary pushback...

To counteract the deflationary forces, central banks have been trying to re-inflate via ZIRP/
NIRP and (currently) about US$180bn/month of QE.
7

Paul Mylchreest
Tel: +44 20 7716 8257
The six major central banks have created more than US$12 trillion since the 2008 crisis.
By removing (via QE) a substantial proportion of safer assets, central banks have amplified
asset bubbles into a wider range of risky assets since US Treasury bonds act as a benchmark
from which to value other asset classes, e.g. in DCF valuations of equities.
It also helps to temporarily sanitise misallocated capital and extends the life of the bubble.
Here is Andrew Lawrence of Rosebrook Capital, writing for Paul Brodskys Macro Allocation
Inc., on one aspect of the distortion only too relevant for active investors.
Consider the armies of analysts and portfolio managers devoting countless time and energy
endeavouring to determine the right price for an asset; cash flow, market share, management, discount rate? All meaningless, as that same asset is being hoovered up by a central
bank with unlimited funding resources and a complete indifference to valueHedge fund alpha generation, or the lack thereof, should be seen through this lens of inefficient capital allocation. If capital is being allocated at the margin by non-profit driven or non-economic driven organizations namely central banks we should expect profit driven organizations that
succeed by wringing inefficiencies out of the market to fail
And for the central bankers, their dreamed of steady state of 2.5-3.0% GDP growth and
2.0% CPI inflation remains elusive.
And
8

Paul Mylchreest
Tel: +44 20 7716 8257
Extreme central bank intervention has detached prices of most financial assets from the real
economy, i.e. the production and consumption of goods and services, as the former attract the
majority of the incremental credit. For example, the next chart shows how the S&P has diverged from orders for durable goods following the implementation of QE3 in November 2012.
The exchange of goods & services is lagging as growth in world trade is currently non-existent.
9

Paul Mylchreest
Tel: +44 20 7716 8257
Lets consider the conflict between deflation and inflation in the real economy.
The trend in commodity prices we use the Continuous Commodity Index based on 17 equally
-weighted commodities - is a useful indicator.
Deflation has generally held the upper hand since 2011.

The PureHeart report recently gave its slant on the deflation versus inflation balancing act,
while drawing attention to the significance of the dollar:
To recap, deflation has been just strong enough to push down bond yields, but not
enough to cause defaults...Central banking policies have created just enough credit to push up
asset prices without causing commodities and consumer prices to spike. The dollar has been
strong enough to suppress emerging markets but not enough break them down.
We should emphasise that we are Endgame Inflationistas.
We expect that all currencies will, in due course, be severely debased by central banks and
governments. Declining value of currencies will ultimately probably in response to a crisis act as the shock absorber to the bursting of the debt/asset bubble. This will reduce the debt
burden and draw the current Long Wave cycle to a close.
Its a tough call, but our current thinking is that it will be a one-two process, i.e. that the
much higher and sustainable inflationary endgame will follow on from a deflationary shock,
e.g. recession, banking crisis or major geopolitical event. It will only be after such an event
that the inflationary helicopters will be revved up enough to cause a loss of confidence in
the value of currencies generally, including the dollar.

Paul Mylchreest
Tel: +44 20 7716 8257
As in other Long Wave cycles, however, there will be deflation at the end of this Long Wave
cycle, but its presence will be more subtle. In fact...
We doubt that it will be measured in what most people think of as money, if you see what we
mean.
However, its clear from the previous chart of the Continuous Commodity Index (CCI) that
there has been a rebound in inflationary pressure since the beginning of 2016.
We acknowledge that this could be the start of the endgame, but we are doubtful.
The chart below shows that, unsurprisingly, there is a close correlation between the CCIs yearon-year change and the G-7 inflation rate.


Paul Mylchreest
Tel: +44 20 7716 8257
In terms of inflation indicators, there are THREE COMMODITIES which we watch very closely
with regard to the conflict between inflation and deflation. The first one is sugar, because it
often leads the commodity complex as a wholeboth up and down.
It was right again in late 2015.
We have no idea why sugar often leads the commodity complex.

Butwhen it comes to impacting CPI rates of inflation, the key commodity is, obviously. oil.
There is a significant base effect in progress as the oil price decline unwinds and turning positive year-on-year.


Paul Mylchreest
Tel: +44 20 7716 8257
Using the current price of WTI crude, the year-on-year increase in the oil price will exceed 40%
during the latter part of 2016.
The next chart shows the correlation between the year-on-year change in oil and US inflation
since 2011. As things stand, inflation is set to pick up in the coming months.
If the inflation scenario continues to unfold, its highly likely that a third key commodity needs
to join the party, i.e. Dr Copper. Zinc has recently made a 5-year high and (even) aluminium
has risen 20% from its 2015 low recent months. In contrast, copper had been dead until the
recent catch-up rally. The next chart shows copper versus sugar since 2004.
Source: Bloomberg

Paul Mylchreest
Tel: +44 20 7716 8257
Sowe should be moving into a more inflationary period characterised by a tailwind for
commodity prices and a headwind for bonds.
Here comes the but...
Before we get too excited, there is a risk to this scenario which remains poorly understood,
and that risk is DOLLAR LIQUIDITY.
The next chart shows the NEGATIVE correlation between the CCI and the dollar index, the DXY.
The inverse correlation with the most important commodity of all is almost perfect.

Paul Mylchreest
Tel: +44 20 7716 8257
It does raise the question how important global GDP growth, OPEC policy, Saudi/Russia talks
and US shale production are for the oil price?
Or...is the US dollar the only thing that matters?
Here is another key indicator of the dollars significance for inflation/deflation.
The dollar has become increasingly central to the global economic outlook.
Indeed, in our opinion, the dollar has assumed a role akin to a GLOBAL FED FUNDS RATE.
We should note at this point that there are effectively two inventories of dollars:
Domestic US; and

Offshore dollars which are termed Eurodollars.
In his 1971 essay, The Euro-Dollar Market: Some First Principles, Milton Friedman recounted
hearing a high official of an international financial organization discuss the Eurodollar market
before a collection of high-powered international bankers. When asked to explain where Eurodollars came from, Friedman described his answer as.
almost complete nonsense.
Eurodollars are dollars in non-US bank accounts, whether in Europe, especially London, or in
other financial hubs, e.g. Hong Kong, Singapore, etc.
We are primarily interested in the Eurodollar inventory although there are flows between the
two (see below).

Paul Mylchreest
Tel: +44 20 7716 8257
To quote the BIS (from Working Paper 483 Global dollar credit: links to US monetary policy
and lever-age 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 off-shore aggregate has behaved quite differently from its larger US aggregate, not least since the global financial crisis
The functioning of both domestic and Eurodollar credit inventories depends on efficient performance of several wholesale money/shadow banking markets including Fed Funds (domestic),
LIBOR (Eurodollars), repo, private market currency swaps and, in times of stress, the provision
of dollar swaps by central banks.
Total offshore Eurodollar debt is now in excess of US$10 trillion.
This scale of Eurodollar debt is a relatively new phenomenon, having risen by 70% since the
2008 crisis. The post-crisis build-up of Eurodollar debt has been dominated by emerging markets (EM) which amount to more than US$3 trillion. Consequently, a rising value of the dollar:
Transmits tighter monetary policy to the rest of the world;

Tightens liquidity in wholesale dollar funding markets;
Undermines financial stability and the banking system, especially overseas banks; and
Is negative for US/China economic relations (more later).
From the non-US perspective, the dollar has effectively been weaponised.
The latest breakout was from a 30-year wedge.

Paul Mylchreest
Tel: +44 20 7716 8257
If the bull market continues, lets not forget that the last two major dollar bull markets coincided with crises
Latin American debt crisis in the early/mid-1980s; and

Asian/Russian debt crises in the late 1990s.
There is another more recent crisis where the dollar and Eurodollar illiquidity in particular
played a central role.
Surprisingly few people appreciate that the critical event in the emergence of the 2007-08 crisis was a dollar crisis, i.e. the BIFURCATION OF DOLLAR FUNDING MARKETS on 9 August 2007.
Two BNP Paribas hedge funds failed to price on that date which led to a scramble for Eurodollar liquidity by banks and funds in Europe, especially London. This led to a sharp rise in LIBOR
rates as you can see in the chart below (red line) as there was no Federal Reserve acting as a
liquidity backstop.
In contrast, the Fed piled liquidity into the Fed Funds market in New York in such volume that
Fed Funds declined (blue line).

Paul Mylchreest
Tel: +44 20 7716 8257
LIBOR and Fed Funds remained bifurcated throughout the crisis, which was ironic with hindsight. In 2005, the NY Fed (no less) observed that.
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 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.
Amateurs.
There are flows between the two pools but, as everybody discovered, they are not wholly integrated, since the domestic one has traditionally been backstopped by the Fed - unlike the Eurodollar market.
Fast forwarding to today and there is an emerging shortage - essentially a run - in dollar
liquidity, which (once again) is focused on Eurodollars.
Its apparent from the analysis below that the Eurodollar shortage is something that even
central banks are struggling control.
Indeed, on a few occasions, they have completely lost control, as well explain.
The first signs of Eurodollar liquidity problems surfaced in early 2014, although hardly anybody
understood what was taking place.
First RMB devaluation

In February 2014, the PBoC began allowing the RMB to devalue versus the dollar following
more than eight years when the trend had been appreciation no small event. Many reasons
were put forward, such as stopping the RMB being a one-way bet, helping the export sector
and part of the shadow banking reform.
The only person who understood its significance at the time (as far as we know) was FT
Alphavilles Izabella Kaminska. She explained that the main problem was a shortage of dollar
funding in the Chinese banking system.
In essence, Chinese banks received the tacit approval of the PBoC to bid more aggressively for
dollars in wholesale funding markets. Consequently, the RMB weakened versus the dollar.

Paul Mylchreest
Tel: +44 20 7716 8257
Source: Bloomberg
It wasnt until later in 2014, that what was happening to the dollar and dollar-related markets
began to become somewhat clearer.
Mid/late 2014 Turning Points

Shortly after the RMB was devalued for the first time, the cost of borrowing Eurodollars, in
terms of the benchmark 3-month LIBOR rate, bottomed out.
Source: Bloomberg

Paul Mylchreest
Tel: +44 20 7716 8257
The RMB devaluation pre-empted the surge in the US Dollar Index (DXY) which gathered pace
in mid/late 2014.
The middle of 2014 also saw the low in volatility as represented by the VIX.

Paul Mylchreest
Tel: +44 20 7716 8257
At the same time, the frequency and magnitude of Fails to Deliver (FTDs) in the repo market
began to rise. The repo market is a nexus for leverage in the financial system and FTDs indicate
stress in securitised dollar funding markets.
In this case, it is signalling a shortage of high quality collateral which is no doubt exacerbated
by two factors:
QE3 which removed large volumes of Treasuries and Agency MBS from the market on
to the Feds balance sheet; and
Re-hypothecation (since boys will be boys).
The chart above shows that repo remains (very) problematic at times with two sizeable FTD
spikes so far in 2016.
The next chart shows how US banks have been hoarding US government securities, seemingly
reflecting the growing difficulty in accessing high quality collateral.
The latest surge in commercial Banks holdings of US government securities (Treasury and
Agency) coincided with the implementation of QE3 in November 2012.
It has continued almost unabated since

Paul Mylchreest
Tel: +44 20 7716 8257
Source: Bloomberg
Indeed, if it wasnt for the Feds Reverse Repo programme (since September 2013), we
would have almost certainly have seen a repo crisis by now.
Lets look at Eurodollar flows
As we moved into late 2014, there was a significant reversal in dollar flows. From 2011-14,
banks had moved huge volumes of dollars from offshore Euro-dollar markets into domestic US
money markets.

Paul Mylchreest
Tel: +44 20 7716 8257
This has been a response to regulatory change in the US (FDIC assessment tax) and Fed policy
(QE2, QE3 and IOER). Since late 2014, this flow has reversed to the tune of more than
US$400bn - reflecting measures on the part of banks to shore up their Eurodollar funding
needs.
The end of 2014 saw another significant market trend develop which has a read across for Eurodollar liquidity, even if most people have missed it.
The 30-year swap spread moved into negative territory and has moved further into negative
territory since. A swap spread is the difference between the yield on a Treasury and the fixed
rate of a fixed-for-floating swap with equal maturity.
Negative swap spreads are an anomaly.
Theoretically, swap spreads should not trade in negatively, as it implies that the banking systems credit is superior to the US Treasury. The fact that swap spreads are negative probably
most likely reflects the reluctance of the banks to use (for themselves) or provide dollar balance sheet capacity to arbitrage them away.
Straitjackets are being applied to the big Eurodollar bank balance sheets due to, for example,
growing risk aversion and the implementation of Basel III (e.g. Liquidity Coverage Ratio). This
has made JPMs, Citis and BoAs, etc, less willing to extend vast globs of dollar credit.
So
By the end of 2014, stress in Eurodollar funding and bank balance sheets had emerged.

Paul Mylchreest
Tel: +44 20 7716 8257
SNB breaks the peg

On 15 January 2015, the Eurodollar liquidity problem led to a high profile market event the
abandonment of the Euro peg by the Swiss National Bank (SNB). The SNB specifically mentioned central bank policy divergence and dollar strength in its statement ex-plaining why it
ended 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.
By far the most interesting chart is not the Swiss Franc (SwFr) versus the Euro but versus the
dollar.
The initial strength in the SwFr following the announcement quickly gave way to renewed
weakness, taking it almost back to the level it started. Its our belief that this reflected major
Swiss banks stepping in to cover their Eurodollar shorts which had become a huge problem
when the SwFr was tied to a weakening Euro.

Paul Mylchreest
Tel: +44 20 7716 8257
BoJ loses control of the Yen hidden role of the Eurodollar

In Japan, the reckless Abenomics policies were implemented in the wake of the December
2012 election victory. It made a deteriorating trend in real household expenditure even worse.
The BoJs expanded QE programme is buying bonds and ETFs at an annualised rate of 17% of
the nations GDP.
It was hardly surprising that the Yen collapsed from 82.0 versus the dollar to over 125.0 by the
middle of 2015. By August 2016, the Yen had confounded many by recovering all the way back
to 100.0.
These substantial Yen moves can be explained in terms of Eurodollars.
Well begin with the cross currency basis swaps (CCBS) which have increasingly signalled a
structural dollar shortage vis--vis other major currencies, including the Yen. CCBSs represent
the funding cost from swapping deposits from one currency into another currency versus covered interest parity at a fixed exchange rate (so the currency is hedged) and for a specified
time period.
In a benign market environment, where the desire to swap from one currency to another is
neutral, along with the relative counterparty risk, the CCBS should trade at zero a bit like
swap spreads.

Paul Mylchreest
Tel: +44 20 7716 8257
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.
If we look at the Yen CCBS, it was in negative territory, generally -5 to -30 bp, through the latter
part of 2015, which coincided the period when the Yen was weakening.
Now for the counterintuitive bit

In late 2015 and mid-2016, the Yen CCBS fell sharply despite the Yen strengthening significantly
versus the dollar.
How could the markets desire to swap Yen into dollars become much greater with the CCBS
indicating a structural shortage of dollars relative to Yen - at the same time as the Yen
strengthened 20%?
Hmmm, a conundrum.

Paul Mylchreest
Tel: +44 20 7716 8257
To answer the question, we have to delve further into counterintuitive market action, i.e. that
a major factor in the weakness of the dollar versus the Yen was precisely due to the Eurodollar
liquidity shortage.
It relates to leveraged Yen carry trades.
We have modelled a plain vanilla Yen carry trade where borrowed Yen is swapped into dollars
and reinvested in 10-year US Treasuries. Basically, profit on the carry trade has been eliminated with two legs of the trade impacted by tighter Eurodollar liquidity:
The rising cost of the swap, i.e. more negative Yen CCBS; and
The rising cost of dollar borrowing, i.e. 3-month LIBOR.
The chart below plots the return (carry) in basis points and the calculation uses 3-month tenors
in LIBOR, Yen LIBOR and the Yen Cross Currency Basis Swap.
As profitability was eliminated, dollars were sold and Yen borrowings bought back, leading to
Yen strength.
It might not be a coincidence that the elimination of profitability coincided with the recent low
in the Yen.

Paul Mylchreest
Tel: +44 20 7716 8257
Deutsche Bank crisis

Deutsche Bank is the highest profile casualty of the longstanding European banking crisis. Since
2007, it has lost 85% of its value.
Source: Bloomberg
However, DB is only one of many banking fallen angels with other victims like Spains Banco
Popular and Belgiums Dexia, whose share prices have fallen more than 90%.
Now to the Eurodollar linkif we think about the latest DB scare in late September/early October 2016, this coincided with another plunge further into negative territory in the Euro/US
CCBS, implying a scramble for dollar liquidity in the European banking system.


Paul Mylchreest
Tel: +44 20 7716 8257
Both the Yen CCBS, the Euro are implying dollar shortage and we see are seeing the same story
with Sterling, Swiss Franc and Canadian Dollar, etc. Here is the Sterling 3-month Basis Swap.
Source: Bloomberg
If Eurodollar liquidity shortage becomes critical, there is a degree of backstop in the form of
dollar swap arrangements between the Federal Reserve and 5 other central banks, the ECB,
BoJ, BoE, SNB and Bank of Canada. At the peak, the Fed had US$558bn of dollar swaps outstanding ln the 2008 crisis, although it failed to prevent the crisis.
A key point
The Feds current dollar swap arrangement is with developed world central banks. As stated,
the 70% of increase in offshore dollar debt since the crisis has been dominated by the emerging world, especially China. Consequently, the lack of a dollar swap arrangement with China is
a glaring omission on the part of the Federal Reserve.
Chinas Eurodollar problem

In 2014, the BIS estimated that Chinas dollar debt to non-financial borrowers amounted to
US$1.1 trn, an increase of US$0.9 trn since 2008. This figure excludes a further US$0.6-0.9 trn
of dollar debt in Hong Kong and additional Chinese dollar debt raised in other hubs, e.g. Singapore.
In aggregate, Chinas dollar debt is likely more than US$2.0 trn.

Paul Mylchreest
Tel: +44 20 7716 8257
Since the initial devaluation in February 2014, the trend in the RMB has generally been characterised by PBOC interventions (red circles) followed by renewed devaluation.
Indeed, the second formal RMB devaluation on 12 August 2015 seems less significant in light
of the subsequent weakness.
In our opinion, the risks facing Chinas financial system and therefore its economy are FAR
HIGHER degree of stress than is currently realised due to dollar Illiquidity.
This chart from the BIS is a good illustration of the topology of a Chinese corporate which borrows dollars from a regional bank in Hong Kong.
Source: BIS

Paul Mylchreest
Tel: +44 20 7716 8257
It shows two classic problems which occur time and again in liquidity crises:
A currency mismatch in terms of the dollar; and
A maturity mismatch with the Hong Kong bank borrowing short-term in wholesale funding markets and lending long-term to the Chinese corporate borrower.
But its more complicated than that.

The market seems to believe that the PBoCs liquidation of forex reserves has been primarily
directed at defending the value of the RMB.
In part, we agree. However, we also think that it has more to do with the need to rollover the
dollar funding which is desperately needed by the domestic banking system.
Which seems to be exacerbating another problem for Chinese banks.
By countering dollar illiquidity using forex reserves, we suspect that the PBoC has contributed
to domestic RMB illiquidity, thereby risking domestic economic growth. For example, if the
PBoC exchanges its dollar reserves with domestic banks in exchange for RMB, the volume of
RMB in the Chinese banking system (money markets) will contract.
If so, one would expect that tighter RMB liquidity would put upward pressure on short-term
Chinese money market rates.

Paul Mylchreest
Tel: +44 20 7716 8257
During Spring/Summer 2016, we argued that it seemed that the PBoC was trying to cap overnight SHIBOR at 2.0%. Whether this was the case or not, and we think that it was, SHIBOR has
been on a rising trend since late Summer.
Source: Bloomberg
In similar fashion, Chinas version of the TED spread is on the rise again. The two previous
spikes coincided with the two RMB devaluations in February 2014 and August 2015.

Paul Mylchreest
Tel: +44 20 7716 8257
As far as we can tell, the PBoC has been trying to prevent a surge in Chinese money market
rates by (literally) flooding the domestic banking system with RMB liquidity. The flood currently
stands at RMB 4.68 trn, or almost US$700bn.
Presumably the PBoC is hoping that the liquidity creation is either internalised or that we
wont notice. The extent to which the PBoC is intervening reflects the fragility of the status quo
in the Chinese financial system. A further complication is capital outflow from the mainland.
The weakness of aggregate Chinese imports in aggregate during 2015-16 has been on a par
with what happened in the wake of the 2008 crisis.


Paul Mylchreest
Tel: +44 20 7716 8257
In stark contrast, imports from Hong Kong have surged as over-invoicing has been one method for capital to exit the Chinese mainland.
Another conduit for capital outflow is Bitcoin.
In a world suffering from the lack of Eurodollar liquidity, where the focal point is China, the
CNY rate acquires near enormous significance.
While the BoJ lost control of the Yen, the PBoC losing control of the RMB would have graver
consequences.

Paul Mylchreest
Tel: +44 20 7716 8257
Risk assets sense thisthe S&P 500 sold off sharply following the RMB valuation in August
2015. There was also a noticeable correlation between corrections in the S&P 500 and RMB
weakness during end 2015/beginning 2016 and mid-2016.
Given the renewed weakness in the RMB, we are clearly in a higher risk phase for equities.
There is also the risk that the correlation between the RMB and commodities, which was reasonably good until May 2016, reasserts itself.


Paul Mylchreest
Tel: +44 20 7716 8257
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be aware that they may not realise the initial amount invested, and indeed may incur additional liabilities. Investments in futures, options and foreign exchange entail above average risk, investors should
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Equity & Cross Asset Strategy

Commodity Prices & Inflation

We know the narrative...Trump equals higher inflation, a tailwind for

In his recent speech, Is There a Liquidity Problem Post-Crisis?, Fed Vice

Dollar Index (Inverted)

OECD G7 CPI (yoy %)

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Source: ADM ISI, Bloomberg

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Panic of 1873; and

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Source: ADM ISI, Bloomberg

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creating a new bubble larger than the prior one.

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Inflation (or Re-inflation)

The global debt bubble;

The pre-eminent deflationary force is the debt bubble.

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The inflationary pushback...

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Source: ADM ISI, Bloomberg

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Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

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Deflation has generally held the upper hand since 2011.

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Source: ADM ISI, Bloomberg

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Source: ADM ISI, Bloomberg

We have no idea why sugar often leads the commodity complex.

Source: ADM ISI, Bloomberg

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Source: ADM ISI, Bloomberg

Equity & Cross Asset Strategy

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Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Equity & Cross Asset Strategy

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Domestic US; and

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Transmits tighter monetary policy to the rest of the world;

Source: ADM ISI, Bloomberg

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Latin American debt crisis in the early/mid-1980s; and