The Portfolio Construction Strategistof collateral values against which the loans are being made on the basis of, which in turn makes it easier to ... inevitably run as far and as

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The Portfolio Construction Strategist

Global Asset Allocation Research & Strategy 21st July 2017, PCS015: USD Series

When we look out at the world, we have several key questions

always that we are grappling to come to terms with:

1. What are the primary underlying conditions that are

framing and driving change?

2. What is ‘in the price’ of each of the major asset markets?

3. Where are the majority likely to be wrongly positioned?

(And over what timeframes?)

PCS Reports are designed to help us establish a foundation

towards answering these questions.

The bearishness towards the US Dollar generally has become quite pronounced as this year has progressed.

However, the singularly most important dynamic that under-girds US Dollar analysis (that I find is almost

universally ignored, or underappreciated, by the vast majority of participants) is the critical backdrop of

the globalised banking system and collateral situation.

The aim of this report is to provide some context around such in addition to seeing what this actually looks

like in chart/data/practical form – gaining some sort of a sense for where we might be in the progression,

and within the broader USD bull market. [For the sake of brevity, this report assumes a basic familiarity

with our ‘First Principles’ explanations as outlined within PCS 011 & 012 earlier in the year.]

CONTEXT: Sources of Liquidity for Financial Markets

Ultimately, the primary sources of liquidity for financial markets (claims on ‘assets’) are these:

1. Savings (out of income)

2. Banking system lending towards (hopefully productive) enterprise & activity (i.e. the primary

expectation of repayment of principal and interest is from an underlying income stream/source,

usually from productive private enterprise)

3. Banking system lending against collateral values (i.e. where a financial institution provides a

credit balance - i.e. a loan liability to the borrower - using some collateral/asset as primary security

for the loan as opposed to some positive inquiry and expectation that there is sufficient productive

income source behind the loan to ensure repayment of principal and interest, property booms

always devolve more and more into collateral based lending as it ensues which is why the busts

are typically deflationary and painful).

4. Central Bank money creation (i.e. printing money, creating deposits in favour of the public or

private sectors etc)

In the current system (i.e. last 30 years), by far the largest source of liquidity creation within the broader

globalised system has progressively been from lending activities against collateral.

Liquidity creation against collateral values is surprisingly the worst of all forms as it lulls participants into

a false-sense of security (central bank liquidity creation is usually fairly obvious to all, as are the maladies

that are impelling such actions). There’s a reflexive dynamic at the core of such lending where a loan on

the back of collateral creates new liquidity, as this new liquidity can in part (or in whole) increase the values

of collateral values against which the loans are being made on the basis of, which in turn makes it easier to

lend even more in a collateral-backed manner. Things really get out of control in this reflexive process

when the same piece of collateral (‘asset’) is used to secure multiple new loans which creates substantially

more new liquidity than the ‘value’ of the collateral. Because lending against collateral is NOT typically

on the basis of an underlying income stream (as the primary source of intended repayment of principal and

interest), such lending and liquidity creation can only be sustained within an economic system provided

that either (a) liquidity can continue to be created in a like manner (or is sucked in from elsewhere in the

system) to fund the overall structures created, or (b) there is a veneer of ‘growth’ about the whole system

wherein a portion of such is redirected to sustaining/maintaining the parasitic-like collateral-backed-

lending. A great descriptive for collateral-backed lending is ‘fog wealth’...

“I began to realize that the big money must necessarily be in the big swing.

Whatever might seem to give a big swing its initial impulse, the fact is that its

continuance is not the result of manipulation by pools or artifice by financiers, but

depends on underlying conditions. And no matter who opposes it, the swing must

inevitably run as far and as fast and as long as the impelling forces determine.”

…Jesse Livermore (1877-1940)

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US Dollar Structural Perspectives: The Banking & Collateral ‘Blind-Spot’


Global Asset Allocation Research & Strategy 24th September 2017, PCS017: USD Series

“The enemy of conventional

wisdom is not ideas, but the

march of events.” ...John Kenneth Galbraith

(1908-1937)

http://www.prerequisite.com.au/







“Permanent wealth is produced by the slow process of industry, combined with skill and the manipulation of capital.

Fog wealth is produced by the rapid process of placing one piece of paper in the possession of a bank as a collateral

security for two pieces of paper. Some of the enormous quantity of fog wealth which is being created will sooner or later

collapse.”

...King O’Malley, Big Battle, 1939

(somewhat ironically, given the bank’s activities over the last 15 years, O’Malley

was one of the founding architects of the Commonwealth Bank of Australia)

Obviously, anyone familiar with the modern practices of the major banking institutions of the world over

the last 20-30 years will immediately recognise the gravity of the situation we’re presently in globally

(partially explained in PCS 011 and PCS 012 within our First Principles discussions – Part ONE & TWO)

wherein we have seen liquidity derived from collateral-backed lending practices proliferate in a manner

and size that lacks historical precedent... particularly with regards to the inter-bank funding markets (which

have morphed well beyond just banking activities to being funding sources for business and financial

enterprise around the world), Eurodollar and OTC derivative markets.

Systems that have an excessive proportion of liquidity created in a collateral-backed manner progressively

devolve into Ponzi-like conditions, as well described by the late Dr. Kurt Richebacher as related to the

growing issues building within the US property markets...

“The expression "Ponzi finance" — derived from some fraud in 1919-20 — simply means that lenders capitalize unpaid

interests, rather than adding them to their bad loan reserves. As this credit creation involves no new spending on the part

of the borrowers, it also involves no money creation. There is, in short, no cash flow. But as the increasing collateral from

the housing bubble appears to create rising wealth and collateral on the part of the illiquid borrowers, nobody cares. The

pleasant counterpart to this credit creation for the lenders is profit creation. With this reasoning, the banks are setting

aside lesser and lesser reserves against possible losses. There is, in short, no cash flow. But as the increasing collateral

from the housing bubble appears to create rising wealth on the part of the illiquid borrowers, they do not care. For the

lending institutions, the pleasant counterpart to this credit creation is corresponding profit creation. With the same

reasoning, the banks are setting aside lesser and lesser reserves against possible losses.”

…Dr. Kurt Richebacher, The Richebacher Letter (October 2005 – 388)

In the present system, where moral-hazard is prevalent among ‘too big to fail’ institutions, where bank

executives know that the latent risks will be bailed out by the government if (when) the system becomes

too unstable (not to mention the execs are still collecting their bonuses as short-sighted earnings targets are

met etc)... it is easy to see how we have arrived at the point we’re at where the build-up of these excesses

in the broader global system are mind-boggling to comprehend.

“The continuous injection of additional amounts of money at points of the economic system where it creates a

temporary demand, which must cease when the increase of money stops or slows down, together with the expectation of a

continuing rise in prices, draws labor and other resources into employments which can last only so long as the increase

of the quantity of money continues at the same rate--or perhaps even only so long as it continues to accelerate at a given

rate . . . would rapidly lead to a disorganization of all economic activity."

...F. A. Hayek (1899-1992)

When excessive collateral based lending – and ‘under-productive’ lending practices more generally –

approaches a saturation point within an economic system, you will see the following progression unfold...

1. PRODUCTIVITY ISSUES: First velocity starts falling, which is another way of saying the

productivity of newly created liquidity (and debt etc) is falling... falling productivity basically means

that progressively ‘less-useful’ output and economic activity is being created for every new dollar

in liquidity (or debt) brought into existence – it progressively reflects misallocation and is

symptomatic of unsustainability and ultimately wastage – it’s the build-up of debt, investment and

resource allocation structures that are either unproductive or ‘under-productive’ within a system.

Existing real-capital stock is neglected or run down in favour of further financial or favoured-

collateral related activities. GDP/M2 ratios fall, debt to GDP & debt to various income ratios explode

higher, and banking system assets to economic activity ratios move higher. Economic growth begins

to moderate and even stagnate, productivity trends typically also tend to decline, financial

engineering & speculative pursuits gain ascendency over actual ‘real-world productive’ activities.








2. REPRESSION & DEFERRAL: Next, stresses begin to build towards the recognition of the

underperforming loan and investment structures that have accumulated which also dampens

new liquidity creation appetites, dampens new real-capital formation appetites and as the

dynamics build can start to be seen in devaluation ‘incentives’ in currency markets (depending

upon the system context). Financial repression proliferates in its many forms, more visibly in

interest rate manipulation that seeks to lower the cost of capital in order to avoid the shake-out of

underproductive structures. As the effective cost of capital approaches zero the deteriorating return

on (real) capital also increasingly becomes more visible. During this phase, ‘extend & pretend’

practices throughout the financial and public sectors tend to proliferate as the building asset-

impairment and non-performing loan cycle is sought to be delayed and deferred. This kind of is the

‘suppressed risk & volatility’ phase (in more modern parlance), the deferral of the reckoning and

apparent suspension of the laws of ‘economic gravity’. You could also characterise this stage as

being one of ‘denial’, but this is only amongst the majority of participants (usually), as usually the

very existence of repression and deferral behaviours in part is the explicit acknowledgement that

there are indeed substantial risks lurking below the surface of the system (or why else would such

financial repression be necessary?).

3. DISTRIBUTION & TIPPING POINTS: Past a point (assuming there are

no external catalysts that force unexpected instabilities), insiders to the

liquidity & economic system begin to capitulate and start to exit or

attempt to protect themselves. At this point they see the risks (and problems)

to their further participation beginning to outweigh the potential rewards – they

become increasingly more cautious in their activities and behaviours (even

seeking to profit from the inevitable ‘unwind’ if possible). In certain

circumstances capital flight might also begin to escalate noticeably. There’s

almost a self-fulling type dynamic at play during this phase as confidence

progressively breaks.

4. THE RECKONING: Economic gravity reasserts itself – forced liquidations occur and ‘illiquidity’

presents itself in expanding volatility... the non-performing loan & asset impairment cycle escalates

and makes itself felt in diverse areas as it’s unable to be further deferred or delayed. Because of the

nature of the modern money, credit and collateral system, the initial phases of this process tend to

be disinflationary if not outright deflationary in nature as money and leverage structures collapse,

and non-quality collateral is revealed for what it is, a mirage (or ‘fog wealth’)... hence in the initial

stages of this dynamic there is a significant ‘bid’ for apex assets of Exter’s inverted pyramid as

essentially ALL participants seek to scramble up the quality spectrum in order not to be caught up

in the ‘collateral’ damage of revealed mass misallocation of capital and resources. The calculus

typically is one of ‘bargaining power’, trying to ascertain where and to whom the bill will fall – what

sectors, what groups, what people will pay for the previous excesses.

To summarise, the world essentially entered Stage 1 in a noticeable way about 20 years ago (and it continues

today still). Although you could quite validly argue that you could see the threads of Stage 2 also about 20

years ago, it didn’t more decisively become significantly noticeable in the world until about 10 years ago

(particularly post the 2008 crisis) with Stage 2 characteristics becoming more and more pronounced ever

since. Over the last 2-3 years, we have increasingly been witnessing the early beginnings of Stage 3...

However, within the last 6 months we are starting to see the more decisive signs that we are indeed starting

to enter Stage 3 in earnest.

Our ‘best guess’ at the possible timing of when Stage 4 could appear was detailed in PCS 014 a few months

ago wherein we looked at some different ways to gauge where we probabilistically ‘might be’ at in terms

of the overriding Asset-Impairment & Sovereign Default cycles.

There are many aspects that need to be covered, both relating to where the global system is at, and also how

this relates to the US Dollar in more practical terms.

But before we get into some of the more practical aspects, it is worth segueing via an interesting excerpt

that seeks to describes aspects of the dynamics we’re observing through the lens of a ‘negative growth’

system...

“If risk is concealed from lenders (or shifted to

others) risk-taking becomes excessive.

Although initially manifest as boom,

[e]xcessive risks are converted in time into

excessive losses.”

...Garrison, 1994,

(Hayekian Triangles and Beyond)

“Panics do not destroy

capital, they merely reveal

the extent to which it has

been previously destroyed by

its betrayal into hopelessly

unproductive works.”

...John Stuart Mill (1868)








...'negative growth' systems have distinct faces, but one aspect unites

them. On the surface they all appear to be benign. The mythologies

that generate the illusion of positive growth, therefore, makes their

true nature hard to detect. Still, one needs to become aware of them

so as not to fall victim to the effect which is the effect of 'negative

development.'

Negative development can be understood as a development based on

faulty assumptions. It is a development which generates a certain

type of growth which is destructive to life...

For example, if one owns a share in a corporation that is bought at

fair value, then, there exists a physical equality between the capital

value of the share and the physical value it represents. If the share is

subsequently sold at an increase, while the value of the company

remains the same, that increase in the value of the share is a fictitious

capital value that has no physical equivalent, either in terms of any

value to the society, or in terms of value to the owner of the

share. However, this increase, which is a fictitious capital value, is

financed with real capital by the purchaser. The fictitious capital

growth, therefore, while it registers real growth, is destructive, for the

process of acquiring fictitious capital value draws real capital away

from the physical economy into fictitious assets that have neither real

value in themselves nor afford any tangible profit for the advance of

society. The result is, that the productive development of the society

stagnates as capital resources are drawn out of the productive

economy into the fictitious markets.

If in turn, the fictitious capital value (the increase that has no physical

equivalent) is traded through a financial system that exists exclusively

for the purpose of trading fictitious aggregates, then, the whole

structure involved becomes fictitious, though it grows in leaps and

bounds, while it is constantly increasing its toll on the physical

economy. Soon, its base expands into a conglomeration in which the

entire aggregate of the fictitious system becomes leveraged upon ever

smaller relationships to anything real or of actual value. The most

powerful markets, today, trade nothing at all that is real, but trade

pure speculation.

The main mechanism within the system that forestalls the natural

reversal into collapse, up to a certain point, is the dynamic growth in

the fictitious market that mimics the normal patterns of life. For as

long as the fictitious bubble grows, it appears healthy and keeps on

growing as people pour money into it. By the same token, for as long

as this system can be kept growing artificially, or the appearance of

growth can be created, the built in tendency to unleash a reverse

leveraging can be contained and be held in check. This principle is

exploited in the form of aggressive manipulation of the markets. The

central banks control the game by means of interest rate manipulation

that enables more or less capital to flow into the fictitious system, by

which to spurn its growth, or to prevent it from exploding into thin

air.

Growth is the fictitious system's life-line. The fictitious system can be

maintained only by drawing ever greater amounts of real capital out

of the physical economy with which to drive the trading in the markets

to ever greater levels of financial inflation. Without this infusion of

cash that creates profit for some, there is no incentive for trading in

the fictitious capital markets. Once the cash infusion stops, the

trading stops. And as soon as the trading stops, the financial

instruments traded, which usually have value only through trading,

become suddenly valueless, as fictitious capital aggregates are.

The growth potential of this self-leveraging 'negative growth' system

is phenomenal. It is phenomenal, because it is decoupled from the

physical economy or anything real. The growth in the fictitious

system can be made infinitely attractive to the 'investors' as its profits

do not depend on what is physically possible in the productive

economy. It unfolds in a dream-world where the imagination is the

limit. This is why it is possible to achieve a hyperbolic tendency in

the growth of financial aggregates and resulting profits.

Naturally, as this growth is progressing, the vulnerability within the

system increases in like manner, so that we have also a hyperbolic

growth tendency in vulnerability. Eventually, when the growing of

the system can no longer be sustained through new inputs into it, the

vulnerability becomes paramount, which at this point has reached a

precarious state and reverses its leveraging by which the whole thing

disintegrates.

The point of disintegration is the point at which the feed capital

requirement for keeping the system growing, exceeds the capital

resources that can be pulled out of the real economy of the

nations. Since the society's capital resource is constantly shrinking,

as the productive economy is collapsing, a discontinuity will be

reached, at which point the growth of the bubble stops and the bubble

implodes under reverse leverage.

...Discovering Infinity, by Rolf A.F. Witzsche

(2006, Volume 1a, Ch.12)

MSCI World Banks vs.

the World Share Market

World Banks

outperforming

The World’s Banks

under-performing

All Countries, BIS Cross-Border Positions, External

Deposits, Amounts Outstanding, USD

BIS, OTC Derivatives, Notional

Amounts Outstanding, Total, USD








APPLICATION: Global Banking and the US Dollar

This section will walk through the above framework, introduced on page 2, and start to relate this to what

is happening in the world in more practical terms.

[repeated from page 2...] When excessive collateral based lending – and ‘under-productive’ lending

practices more generally – approaches a saturation point within an economic system, you will see the

following progression unfold...

1. PRODUCTIVITY ISSUES: First velocity starts falling, which is another way of saying the productivity of newly

created liquidity (and debt etc) is falling... falling productivity basically means that progressively ‘less-useful’ output

and economic activity is being created for every new dollar in liquidity (or debt) brought into existence – it

progressively reflects misallocation and is symptomatic of unsustainability and ultimately wastage – it’s the build-up

of debt, investment and resource allocation structures that are either unproductive or ‘under-productive’ within a

system. Existing real-capital stock is neglected or run down in favour of further financial or favoured-collateral related

activities. GDP/M2 ratios fall, debt to GDP & debt to various income ratios explode higher, and banking system assets

to economic activity ratios move higher. Economic growth begins to moderate and even stagnate, productivity trends

typically also tend to decline, financial engineering tends to gain ascendency over actual ‘real-world productive’

engineering, etc.

Clearly, the velocity story has been in place for

decades now (see chart to the right)...

And even in 2017 we are still seeing world

debt to GDP ratios expanding.

Our more tactical measure of global banking

system liquidity shows a problematic velocity

environment for the last 10 years, with the last

3 years starting to become more pronounced,

note that this includes Central Bank activities

(see chart below)...

World Banking

System Liquidity...

Conventional Velocity

Measurement...

US 10yr

Bond Yield

US Dollar Index

(inverted)

strengthening

USD

Velocity of Liquidity

(6mth ROC)

Quantity of Liquidity

(6mth ROC)

Total Effective Liquidity

USA, Europe, Japan, China

(Qty + Velocity, 6mth ROC) Pronounced velocity

deterioration

Velocity of World M2

USA, UK, EU, JP, China

(World GDP/M2)











2. REPRESSION & DEFERRAL: Next, stresses begin to build towards the recognition of the underperforming

loan and investment structures that have accumulated which also dampens new liquidity creation appetites,

dampens new real-capital formation appetites and as the dynamics build can start to be seen in devaluation

‘incentives’ in currency markets (depending upon the system context). Financial repression proliferates in its

many forms, more visibly in interest rate manipulation that seeks to lower the cost of capital in order to avoid the

shake-out of underproductive structures. As the effective cost of capital approaches zero the deteriorating return on

(real) capital also increasingly becomes more visible. During this phase, ‘extend & pretend’ practices throughout the

financial and public sectors tend to proliferate as the building asset-impairment and non-performing loan cycle is

sought to be delayed and deferred. This kind of is the ‘suppressed risk & volatility’ phase (in more modern parlance),

the deferral of the reckoning and apparent suspension of the laws of ‘economic gravity’. You could also characterise

this stage as being one of ‘denial’, but this is only amongst the majority of participants (usually), as usually the very

existence of repression and deferral behaviours in part is the explicit acknowledgement that there are indeed

substantial risks lurking below the surface of the system (or why else would such financial repression be necessary?).

Obviously, we have seen financial repression writ-large in all of the major regions of the world for the last

decade especially. Zero/Negative Interest Rate Policy and Quantitative Easing in its many forms being

stand-out features. New lending appetites for real economic activity globally have been depressed, as has

been the propensity for capital formation (rather the major corporations of the world have preferred

‘financial engineering’ as a superior spend to even reinvesting into their own businesses). Outside of

monetary policy activism, the apparent solution of the broader global system to deal with the debt problem

has been even more debt (the productivity of which has continued to fall).








Understanding the Structural US Dollar Shortage

As we have explained in previous PCS Reports, by far the vast majority of money/liquidity in the world is

not created by Central Banks, it is created by the broader banking system of the world.

We have also explained at length that there presently exists a situation wherein the demand for US Dollars

in the world far exceeds the available effective supply of US Dollars (as principally created by both US and

Global Banks as a direct consequence of their investment & commercial banking activities).

There is a massive difference between liquidity that comes into existence as a by-product of natural

productive private enterprise activities, and liquidity that comes into existence as a result of either; (a)

collateral-backed speculative activities or (b) Central Bank fiat creation of liquidity.

Central Banks in quantity terms are in the present regime an ‘almost’ immaterial source of liquidity creation,

furthermore, Central Banks typically only provide liquidity to the broader system in a reactive manner –

i.e. if the broader liquidity environment contracts, then this impels Central Banks to attempt to fill the gap.

In some ways Central Banks can ‘in theory’ fill a quantity of liquidity gap created by the non-central bank

sector, but they are unable to fill a ‘velocity’ (or ultimately a confidence) induced gap in liquidity.

As also discussed in previous PCS Reports, when it specifically comes to US Dollar liquidity, the globalised

Eurodollar & wholesale funding market ‘shadow’ banking system is just as important (or even more so)

than the US-domestic banking system in terms of creating the total aggregates of world-wide US Dollar

liquidity. We have fairly accurate data & information on the US-domestic banking system, but the

globalised ‘shadow’ banking system is rather opaque. However, like any complex system, the opaque

‘shadow’ banking system does however manifest itself in more tangible manifestations which allow us to

measure the health and evolution of that system ...and in the following pages of this Report, we will be

surveying the state of such, but first we must first segue into setting the context to the ‘short USD’ position

in the world before moving onto the ‘shortage’ of US Dollar liquidity...

The ‘Short’ USD Positions...

When you buy an asset, you are by definition ‘short cash’, and when ultimately the reserve currency of the

world is US dollars, then in the widest sense you are implicitly short dollars either directly or more-often

indirectly (i.e. you make money if value of US dollars goes down while you hold the asset or commodity).

If you borrow money, then you're extremely short US dollars, you need

to find them to repay your borrowing obligation (i.e. you gain as a debtor

if the USD loses value throughout your loan, but you lose if the USD

strengthens and becomes tighter throughout your loan).

In simple terms, this is why understanding the dynamics affecting the

value of the US Dollar (both absolute and relative) is one of the most

important macro issues globally for any investor or business person.

In an overindebted world, with funding maturity miss-matches writ large

(which is like a debt ‘multiplier’ that is somewhat invisible in a way -

see below and also PCS 011), with unsustainable ‘under-productive’ (or

un-productive) resource allocation structures, in an 'everything' bubble

where asset classes and entire industries around the world are

excessively inflated with the excessively collateral-backed or central

bank created liquidity, then the implicit US dollar ‘short’ is MASSIVE.

Most US Dollar bullish participants will typically point out the below

chart of US Dollar denominated debt outstanding in the world (wherein

a non-US country or company directly borrows money in USDs rather

than their local currency, exposing themselves to substantial currency

risks)... however, this is only just the tip of the iceberg in terms of

‘direct’ short USD exposures that have built up in the world (explained

after the chart on the next page)...

Broad USD

Index

USD Index

??








From what we can ascertain, the propensity for the world to willingly get itself into deeper structurally short

USD positions is related in part to the fallacy of seeing an expanding Fed balance sheet as directly USD

bearish over time (perhaps ultimately it may well be, but in the current and prospective regimes this is not

necessarily the case).

Even though the above BIS statistics suggest that outside of the USA, there is approximately $10.7 trillion

of USD denominated debt, the effective ‘leveraged’ short position is position is potentially twice this

amount (at least)...

“The accounting convention says that Swaps are not debt. There’s a big difference between a Repo (collateralised

borrowing) and a Currency Swap. To really understand this... you have to think about what a Swap is in the currency

market, it is a collateralised loan because what you’re doing is you’re pledging Euros as collateral and borrowing Dollars

against that collateral, and the CIP [Covered Interest Parity] deviation is really a price of borrowing those Dollars against

the collateral. Now, if it’s a collateralised loan, we should be thinking about this as debt, you have the assets that are

proceeds – but the accounting convention says that if the collateral is cash, then you don’t record this transaction as debt

– and for this reason, there is a huge amount of missing debt out there.”

“Why does the accounting convention say that Swaps are not debt? I think the reason is something to do with the fact

that if it’s cash that you’re holding as collateral then this is super-safe, there’s effectively no risk involved whatsoever

because you are borrowing cash by pledging cash, because you’re holding the borrower’s collateral what is there to be

worried about? Of course with collateral, and of course with cash collateral there is no credit risk, but the problem is

really the maturity mismatch, it’s the liquidity.”

“So think back to the story of the European Banks who had invested in US Mortgage Securities using the Swap market

– so what would happen is the banks would Swap Euros for US Dollars on a three month horizon, and then invest in a five

year US Mortgage Backed CDO [Collateralised Debt Obligation], and every three months you would just roll that over.

Now there is no currency risk there because you have the US Dollars for the duration of the Swap... but there is a maturity

mismatch because you have funded a long asset with a short liability – and what we saw in 2008 is that when the mortgage

assets lost value there was a squeeze in the funding because of the usual deleveraging, and then as the debts were coming

due the banks were chasing dollars in order to repay.”

...Hyun Song Shin, BIS Head of Research (13th September 2017 presentation for SciencesPo;

“The Dollar, Bank Leverage and the Deviation from Covered Interest Parity.”)

The BIS have just released their initial estimates as to the potential size of the effective US Dollar short

position due to maturity mismatch issues within swap related markets...

USD Denominated Debt /

World GDP

USD Index

USD Denominated Debt (BIS)

(non USA domiciled)

14% of

World GDP

$10.7

trillion USD








FX swaps and forwards: missing global debt?

Bank of International Settlements (BIS) - by Claudio Borio, Robert

Neil McCauley and Patrick McGuire

17 September 2017

What would balance sheets look like if the borrowing through

FX swaps and forwards were recorded on-balance sheet, as the

functionally equivalent repo debt is?

The outstanding amounts of FX swaps/forwards and currency

swaps stood at $58 trillion at end-December 2016. For perspective,

this figure approaches that of world GDP ($75 trillion), exceeds

that of global portfolio stocks ($44 trillion) or international bank

claims ($32 trillion), and is almost triple the value of global trade

($21 trillion).

The outstanding amount has quadrupled since the early 2000s

but has grown unevenly. After tripling in the five years to 2007, it

fell back sharply during the GFC, even more than international

bank credit. This most likely reflected a reduction in hedging needs,

as both trade and asset prices collapsed.

The dollar reigns supreme in FX swaps and forwards. Its share

is no less than 90% (Graph 2 below), and 96% among dealers. Both

exceed its share in denominating global trade (about half) or in

holdings of official FX reserves (two thirds). In fact, the dollar is

the main currency in swaps/forwards against every currency.

... the BIS has been regularly publishing estimates of the dollar

debt of non-banks outside the United States. These cash market

obligations, both bank loans and bonds, totalled $10.7 trillion at

end-March 2017. What would be the corresponding additional debt

borrowed through the FX derivatives markets? As we explain next,

the order of magnitude is similar: the missing debt amounts to some

$13-14 trillion. But the implications for financial stability are quite

subtle and require an assessment of both currency and maturity

mismatches.

... the short maturity of most FX swaps and forwards can create

big maturity mismatches and hence generate large liquidity

demands, especially during times of stress.

Obligations to pay dollars incurred through FX swaps/forwards

and currency swaps are functionally equivalent to secured debt. In

contrast to other derivatives, agents must repay the principal at

maturity, not just the replacement value of the position. Moreover,

they could replicate those positions through transactions in the

cash and securities markets that would show up on-balance sheet.

But because of accounting conventions, this debt does not appear

on the balance sheet: it has gone missing.


http://www.bis.org/publ/qtrpdf/r_qt1709e.htm#Graph-2







“If risk is concealed from lenders (or shifted to others) risk-taking becomes excessive. Although initially manifest as

boom, [e]xcessive risks are converted in time into excessive losses.”

...Garrison, 1994, (Hayekian Triangles and Beyond)

Whether it’s direct or indirect short exposures to the USD across a multitude of factors, after multiple

decades (leading up to 2007) of relatively stable global capital flow & trade regimes, the dominoes that

have been falling since 2008 have been in the direction of potentially unwinding the cumulatively

unprecedented US Dollar short position.

Visualising the ‘shortage’ of US Dollars in the World...

Having now provided some brief context as to the very large structural short position that has accumulated

in the US Dollar, we now will present some of the different ways we can monitor and ‘see’ the shortage of

US Dollars in the world (apart from the actual price of the US Dollar itself against things).

Given that much of the shortage arises as a result of supply issues – i.e. the globalised banking system is

no longer creating US Dollar liquidity to match the international demand for it – and much of the supply

issues tend to centre around the more opaque global ‘shadow’ (Eurodollar/wholesale) banking system as

opposed to the US domestic banking system... we need to look at the issue from multiple perspectives in

order to generate a clearer picture.

We can see the US Dollar shortage in the following ways (this is a non-exhaustive list), each of which we

will explore in greater detail in the pages that follow...

1. The ‘depression’-like conditions plaguing global banking stocks since 2007

2. Falling aggregates of OTC activity and cross-border banking aggregates

3. Falling/problematic global banking system velocity of liquidity

4. Persistently negative CIP (Covered Interest Parity on currencies) and Treasury Swap spreads

5. ‘Net Due to Foreign Office’ liability balances recorded within the US Banking system

6. Global Capital Flow Disturbance Index - Sovereign Bond capital dispersion/concentration models

that in a practical manner seek to gauge the globalised ‘bid’ for high quality collateral

7. PCM’s Excess USD Liquidity models (covered in PCS 012, still indicative of demand exceeding

effective supply of USD Liquidity).

8. Alternative Gold pricing models utilising larger-market capitalisation, non-gold variables in its

construction to identify excess liquidity trends

To begin with, we will repeat the chart that was on page 4 of this report showing the relative performance

of global banking stocks vs. the MSCI World stock market index (in addition to some of the primary OTC

Derivative and cross-border banking aggregates that are indicative more broadly of receding global banking

balance sheets)...

Clearly, from this chart it

is plain to see that the

world’s banking system

has significant problems

that it has not been able to

overcome since 2007...

hence the slump in balance

sheet expansion or

liquidity creation for the

last ten years.



World’s Banks

outperforming

The World’s Banks

under-performing

All Countries, BIS Cross-Border Positions, External

Deposits, Amounts Outstanding, USD

BIS, OTC Derivatives, Notional

Amounts Outstanding, Total, USD

[ Redacted for Public Release ]








Clearly, it is very difficult for the global economic system to produce ‘sustained’ (i.e. anything more than

‘transitory’) reflationary conditions whilst the global banking system is struggling...

Somewhat unsurprisingly

(given the importance of US

Treasury bonds as the

ultimate form of reserve-

currency collateral in the

globalised banking system),

the correlation between the

relative performance of

global banks and the US

10yr bond yield has

tightened significantly –

with little coincidence we

believe between the

pronounced deterioration of

velocity in the world since

2014 and the near perfect

correlation of Treasury

Bond yields and the fortunes

of the world’s banking

industry...



World’s Banks

outperforming

The World’s Banks

under-performing

US Dollar Index

(inverted)

strengthening

USD


(6mth ROC)


(6mth ROC)


USA, Europe, Japan, China

(Qty + Velocity, 6mth ROC)

Pronounced velocity

deterioration

World Banking

System Liquidity...

Price of Copper

(as a simple proxy of

global ‘reflation’)



US 10yr Treasury

Bond Yield

Rolling 12mth Correlation

Coincidence??








Further to the above, as we’ve highlighted in previous PCS Reports, the existence and persistence of the

theoretically ‘impossible’ (at least according to the text books) negative swap spreads on US Treasury

Bonds in addition to the persistently negative Covered Interest Parities on US Dollar related currency

swaps are totally indicative of a structural ‘shortage’ of US Dollars and malfunctioning within the

globalised banking system. It is also worth noting that despite the correction in the US Dollar Index (2017

YTD), the spreads have remained negative indicating that nothing has actually changed with regards to the

structural USD shortage in the world...


the World Share

Market

US Dollar Index

(inverted)

strengthening USD

Swap Spread,

30yr US Treasury

Swap Spread,

10yr US Treasury

(By Mehul Daya & Neels

Heyneke at Nedbank)

"What is driving markets is bank

capacity... The latest round of FICC

numbers from all of the big banks are

simply atrocious, which means that

these banks aren't making money in

the kinds of money dealing capacities

that lead to a healthy monetary

system... what really matters is

essentially the risk and return of doing

these kinds of things that go on in the

Eurodollar market, and for the last 10

years really, the risk return ratio has

been flipped upside down from what it

was in the pre-crisis era where all of

these banks got bigger as fast as they

possibly could on the idea that there's

very little risk and all return. And

without being able to make money in

the post-crisis era, it's all risk and no

return, so there isn't a whole lot of

increased Eurodollar capacity."

...Jeffry Snider, 4th August 2017

(Real Vision Podcast interview)








Given the increasingly domineering nature

of the global banking system on asset

markets and currencies, before we

continue further with the different ways of

looking at the USD ‘shortage’, we thought

it would be interesting to just briefly

look at the effects on currencies of the

relative ‘cross-currents’ of different

regional banking systems...

US Banks vs.

MSCI World Banks

Broad US Dollar

Index

Europe’s Banks vs.

MSCI World Banks

EUR/USD

Japanese Banks vs.

MSCI World Banks

JPY/USD

UK Banks vs.

MSCI World Banks

GBP/USD

Australian Banks vs.

MSCI World Banks

AUD/USD

Europe’s Banking Dysfunction Worsens

Christopher Whalen (Institutional Risk Analyst),

1st Aug 2017

“Investors who think that Europe is close to

adopting an effective approach to dealing with

failing banks may want to think again... While

some Wall Street analysts are encouraging

investors to jump into EU bank stocks, the fact is

that there remains nearly €1 trillion in bad loans

within the European banking system. This

represents 6.7% of the EU economy, according to

a report and action plan considered by EU finance

ministers earlier this month. That compares with

non-performing loans (NPL) ratios in the US and

Japan of 1.7 per cent and 1.6 per cent of gross

domestic product, respectively.

The Europeans appear to be playing a very

dangerous game. On the one hand, EU officials

talk publicly about getting tough on insolvent

banks and even suspending access to funds for

retail depositors. On the other hand, EU

governments are continuing to bail out banks and

large creditors in a display of cronyism and

business as usual.” https://www.theinstitutionalriskanalyst.com/single-

post/2017/07/31/Europes-Banking-Dysfunction-Worsens

China Financials vs.

MSCI World Banks

CNY/USD

Europe

Japan

USA

UK

Australia

China


https://www.theinstitutionalriskanalyst.com/single-post/2017/07/31/Europes-Banking-Dysfunction-Worsens

https://www.theinstitutionalriskanalyst.com/single-post/2017/07/31/Europes-Banking-Dysfunction-Worsens







The next way to look at the US Dollar shortage in the world is to look at the Net Intra-firm Flows for

Foreign Banks in the USA – essentially the (non US) foreign banks are at the core of the global Eurodollar

system in terms of banks that create and multiply USD deposits outside of the USA and undertake wholesale

funding activities internationally, the majority of foreign banks in the USA are more operationally

equivalent to investment banks than commercial/retail banking operations.

By tracking such intra-firm flows in addition to what they’re doing with their USD cash balances (and how

they’re managing their balance sheets) we are able to literally glimpse by their behaviours the core

dynamics occurring within the globalised banking system, especially as the Eurodollar/wholesale banking

system has grown in significance over the last 35 years... this gives us yet another independent frame of

reference to see the underlying trends pertaining to Excess USD Liquidity (i.e. demand for USD liquidity

vs. effective supply of USD liquidity). Please see also PCS 011 & 012 for background as to excess liquidity

and the Eurodollar/wholesale banking systems etc.

Two of the key line items regarding these intra-firm flows are shown in the following chart...

We will explain how this relates to the US Dollar soon, but first we must note a few things:

• Prior to the 2008 crisis, foreign banks held minimal ‘cash balances’ (i.e. deposits) in the USA –

and those cash balances held were largely deposits with other unrelated depository

institutions/banks in the USA.

• During and post the 2008 crisis, foreign banks started to draw significant ‘cash’ into the USA but

not to be deposited with other banks or deposit taking institutions (reducing their reliance almost

entirely on other banks, particularly non-USA domiciled banks), rather they almost entirely held

their cash directly with the Federal Reserve on deposit. Interestingly, almost nothing (in terms of

USD cash balances) was left in the home country of the bank or with the home country’s central

bank.

Total Assets of US Federal Reserve, lhs (shown as a % of Total US Commercial Banking Assets)

Net Due to Related Foreign Offices (liability), rhs (shown as a % of Total US Commercial Banking Assets)

Foreign Related Offices in USA, Cash Balances (asset), rhs (shown as a % of Total US Commercial Banking Assets)

As a % of US Commercial

Bank Assets...

6mth Rate of Change,

$trillion USD...

Total Assets of US Federal Reserve

Net Due to Related Foreign Offices (liability)

Foreign Related Offices in USA,

Cash Balances (asset)

Net INFLOW of funding from

Foreign Bank to USA Office/Branch Net OUTFLOW of funding to Foreign

Bank from USA Office/Branch











• Prior to the 2008 crisis, over 85% of the reserves held at the Federal Reserve were held by USA-

domiciled banks, post the 2008-crisis over 50% of Fed Reserve Balances are held by Foreign banks

with branches or subsidiaries in the USA.

• Strains (i.e. liquidity constraints) in interbank and wholesale funding markets around the

world essentially show up in behaviours that see USD cash balances and flows return to the

USA from abroad, thereby exacerbating the shortage of effective US Dollar liquidity abroad

available for Eurodollar/wholesale funding market activities.

Essentially, when funding flows move back into the USA from foreign banks and there’s a marginal ‘run

to safety’ to sure up global USD activity (almost like a hoarding or falling velocity type dynamic), it is

tantamount to a ‘deficit of USD Liquidity’ situation (where the demand for USD liquidity out-paces the

effective supply of USD liquidity). When funding is flowing out ‘to’ foreign banks from their domestic

USA branches/offices, then this is functionally symptomatic of ‘excess USD Liquidity’ conditions (where

supply of USD liquidity is greater than demand for USD liquidity).

Returning to the ‘relative banking stocks’ chart from page 13, we can now visualise these dynamics more

clearly as relating to the USD in particular...

The ‘Net Due to Related Foreign Offices’ (grey area in bottom panel of above chart) also is effectively a

marginal liquidity position either in favour of the US Banking system (positive balance in grey) or against

the US Banking system (negative balance in grey) vs. the world... and so it kind of makes sense that the

marginal liquidity conditions of the banking system would lead the US Bank vs. MSCI World Banks Sector

ratio.

US Banks vs.

MSCI World Banks

Broad US

Dollar Index


Net INFLOW of funding from

Foreign Bank to USA Office/Branch Net OUTFLOW of funding to Foreign

Bank from USA Office/Branch

Proximately indicative of a structural

shortage of USD Liquidity in the

Eurodollar/global funding markets

(i.e. USD bullish)

Proximately indicative of a structural

shortage of USD Liquidity in the

Eurodollar/global funding markets

(i.e. USD bullish)

Proximately indicative of a structural excess of USD

Liquidity in the Eurodollar/global funding markets

(i.e. USD bearish)









Of course, hopefully being familiar with our PCS 012 ‘first principles’ report, you will know that we largely

view the USD price of Gold as being mostly just a reflection of global ‘excess USD liquidity’ conditions...

and so it is of no surprise that over the last 35 years, as the international Eurodollar and wholesale funding

markets have grown in importance, that the same ‘Net Due to Related Foreign Offices’ balance seems also

to well define the major multi-decade trend changes in gold...

Interestingly enough, just this week it became even clearer that the Federal Reserve’s bias is towards tightening policy rates and

commencing the wind-down of their QE programs... however, this is occurring at a juncture where in (at least according to this

methodology) global eurodollar/wholesale funding conditions are showing early signs of tightening again (see red circles in below

chart)... every other time since the regime shifted in 2008 when similar circumstances occurred the Fed has had to ease its balance sheet

in short-order, but now for the first time the setup is indicative of a potential ‘wrong-footing’ of the Fed? This will be interesting to

watch unfold...


Shown Inverted

Gold (USD)

Structural Bear Market in Gold (deficit of

USD Liquidity, i.e. structural USD shortage)

Structural Bear

Market in Gold

Structural Bull Market in Gold

(i.e. excess liquidity)

This was also the period

of maximum growth in the

Eurodollar banking system, see

chart on pg. 10, between 2002-2008.

??


Foreign Related Offices in USA, Cash Balances (asset), rhs (shown as a % of Total US Commercial Banking Assets)

Total Assets of US Federal Reserve









Recognising the hyper-sensitivity capital flows have towards a diminishing stock of ‘high quality’ collateral

in the world, we have tried to construct an index where we can measure literally the disturbances to global

capital flows in order to get a sense for the ‘bid’ for high-quality collateral in the world...

High Quality Collateral ‘Bid’ Proxy Index (constructed from capital flow behaviour amongst

the 40 largest sovereign bond markets in the world)

Increasing demand for

high quality collateral

Easing of demand for


US Dollar

Index








High Quality Collateral

‘Bid’ Proxy Index

6mth ROC

Increasing demand for




US Dollar Index

(inverted)

strengthening USD

Swap Spread,

30yr US Treasury

Swap Spread,

10yr US Treasury, lhs

Gold Price (circa $7 trillion

market capitalisation)

‘Bigger Money’ Gold Price derived equivalent (a theoretical model utilising a composite of larger capitalised

market prices – i.e. bigger capital flows reflecting underlying

gold pricing conditions – combining inflation-linked bond

yields, equity risk premia and the US Dollar)








UPDATE: Copper

The popular narrative in metals markets this year pertains to the ‘supply cuts’ in China’s capacity.

Problem is, when we look to the evidence on the ground in China, it appears as though production has

increased (not decreased) throughout much of the metals complex. The China Beige Book (a private data

collection and analytics firm specialising on China) has been writing about this for most of the year and

more recently has become quite vocal on social media to this effect...

Over the last few years we have observed much anecdotal evidence of demand for metals inventories being

used as collateral (frequently being rehypothecated multiple times) to underpin substantial borrowing

structures. This year however, the perception of supply cuts and a generally weakening US Dollar has seen

the price of metals, and in particular copper, jump substantially.

We have written in previous reports that our view of

this metals bounce is likely to prove transitory for a

variety of reasons, but this chart to the right wherein

we overlay the copper price with the COMEX futures

Open Interest (historic all-time highs!) and below it

the rough world supply and demand growth data

wherein essentially we’ve seen falling demand whilst

supply has been sluggish to rising still... suggests that

we could be due for a substantial fall in copper.

Our tactical risk assessment methodology (chart

below) also is indicative of timing being ripe for a

potential fall from here.

COMEX

Open Interest

Copper Price


http://www.chinabeigebook.com/







Further corroborating the potential intermediate top in Copper, is a potential top in Emerging Market

equities...








UPDATE: China

Quite simply, financial pressures continue to build within

China. This year has merely been a temporary reprieve

within a broader context of capital outflows that are likely

to be pressured towards persisting.

The stresses continue to build within China’s financial

system, and although China doesn’t necessarily have a

‘normal’ commercial banking system, the laws of

economic gravity still hold sway – although the anecdotal

reports we’re seeing coming out of China indicative of

‘extend and pretend’ banking practices.

In terms of the framework identified on pages 2 & 3 of this

Report, China is most definitely in Stage 3 (Distribution &

Tipping Points) – but ultimately, China can still persist in

their mode of operation for quite some time yet. We still

see the structural trend towards the depreciation of the

CNY still likely to be intact.

CNY/USD

weakening CNY

GDP/M2

(China)

Banking System Liquidity...

Conventional Velocity

Measurement...


(YOY, China)


(YOY, China)


(Qty + Velocity, YOY, China)








UPDATE: US Inflation

www.prerequisite.com.au

CNY/USD

Proxy, Excess Capital Flow Pressures (Net Financial Economy Capital Flows less PBOC intervention)

Net Inflows

Net Outflows

US CPI (%YOY)

US CPI (%YOY)

%YOY, WTI Crude Oil

Held constant

to Dec

Constant price for

6mths scenario vs.

DXY to 107 by Dec 31

US Dollar Index

%YOY, advanced 3mths








When we step back to gauge the more general

inflation cycles in the USA, we can see that the

current bounce in the CPI or inflation

expectations is supported by neither the

Commodities/Equities ratio (top chart – that

also loosely mirrors the global capital flow sub-

cycle we’ve written about before), nor is it

supported by ‘scarce’ labour & capital

conditions (second chart).

Disinflation in the USA is likely for the next

12-18 months..

Commodity Index / S&P 500 US CPI

(%YOY)'

Non-confirmation

of CPI bounce

US Corporate Profits / GDP

Scarcity of Labour & Capital (falling line means excess spare capacity,

rising line means tightening capacity)

Scarcity of Labour & Capital (shown relative to 60-year mean)

US CPI (%YOY)











3. DISTRIBUTION & TIPPING POINTS: Past a point (assuming there are no external catalysts that force

unexpected instabilities), insiders to the liquidity & economic system begin to capitulate and start to exit or

attempt to protect themselves. At this point they see the risks (and problems) to their further participation beginning

to outweigh the potential rewards – they become increasingly more cautious in their activities and behaviours (even

seeking to profit from the inevitable ‘unwind’ if possible). In certain circumstances capital flight might also begin to

escalate noticeably. There’s almost a self-fulling type dynamic at play during this phase as confidence progressively

breaks.

Aside from anecdotal evidence around the world and across different asset markets, the two primary charts

that suggest we are into stage three are these:

We’ve written about this before, but seeing Patient Money flows so heavily buying Eurodollars (i.e. betting

on short term rates going lower from here) usually is a precursor to a substantial period of weakness in the

world within the next 12-24 months.

Given the latent build-up of risk in the world, any serious downturns or further tightening of conditions will

likely have outsized impact.

The next chart is an update from a few months ago...








The above ‘Fear Index’ seeks to operationalise the principles underneath Exter’s Inverted Pyramid.

Essentially it is a gauge of the money flowing into ‘Apex Assets’ vs. ‘Risk Assets’, with the following

representing each:

• ‘Risk Assets’, comprising of an equally weighted composition of... (i) US Equities, (ii) US

Corporate High Yield Credit Spread, (iii) Emerging Market Equities.

• ‘Apex Assets’, comprising of... (i) US Treasury Bonds (10yr equiv) & Bills/Notes (ave. 1yr

maturity), (ii) US Dollars, (iii) Gold.

When money is flowing into ‘Apex Assets’ more than ‘Risk Assets’ then the fear gauge will be elevated,

when money is flowing away from Apex Assets and towards Risk Assets the fear gauge will be subdued.

The bottom panel of the above chart

shows the ‘Patient Money Flows’ into

Apex Assets (Treasuries, USDs & Gold),

at each buying climax (which occurred

prior to a ‘risk off’ gust of wind

throughout the world), we highlight which

of the Apex Assets saw the greatest

accumulation.

Obviously, we have another situation

wherein the ‘Fear Index’ is subdued, and

the Patient Money buying of Apex Assets

(particularly Treasuries) is at a +2

standard deviation extreme and looks to

still be moving higher (implying still more

buying to come perhaps?).

MSCI World Equity Index

(log scale, rhs)

‘Fear’ Index

MSCI Emerging Markets

Equity Index (log scale, rhs)

Patient Money Flows, Apex Assets

(Bonds, Bills, USDs, Gold)

Buying

Treasury

Bills

Buying

Treasury Bills

& US Dollars

Buying Treasury

Bills & Bonds

Buying

Treasury

Bonds & US

Dollars

Buying

Treasury

Bonds &

GOLD

Buying Treasury

Bonds & US Dollars

Buying Treasury

Notes & Bonds

BUYING

SELLING

fearful

fearless








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providers do not guarantee the data or content contained herein to be accurate, complete

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Information only, and should not be construed in any way as specific advice or advice

to purchase or sell financial securities or products. It has been prepared without

reference to your objectives, financial situation or needs. You should consider the

information in light of these matters and if applicable, buying and inspecting the relevant

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invest. Our publications, ratings and products should be viewed as an additional

investment resource, not as your sole source of information. Past performance does

not necessarily indicate a financial product’s future performance.

Contact Information:

Daniel J. Want (Director)

[email protected]

Darren A. Brind (Director)

[email protected]

phone. +61 498 671 505

a PO Box 144 Morningside QLD 4170

www.prerequisite.com.au


Documents

The Portfolio Construction Strategistof collateral values against which the loans are being made on the basis of, which in turn makes it easier to ... inevitably run as far and as