About the liquidity shock of the US dollar in the early stages of economic recession
Original by Canghai Yitugou, published on October 5, 2023, in Shandong
During the National Day holiday, the overseas capital market was very turbulent, with the yield on 10-year US Treasury bonds soaring from around 4.60% to 4.88%, an increase of nearly 30 basis points.
There are various explanations for this abnormal phenomenon, including but not limited to the US government debt problem, inflation expectations, and interest rate expectations. However, all these explanations imply a major premise - that the US economy is still doing well.
So, will the US economy sliding into a recession lead to a significant increase in the yield on 10-year US Treasury bonds? This question is counterintuitive. However, theoretically, this possibility does exist.
This article intends to help everyone understand the increase in the yield on 10-year US Treasury bonds from the perspective of economic recession.
Price-guided vs Quantity-constrained Monetary Systems
First, we need to understand the monetary system in the United States, which is very different from China's. The US monetary system is price-guided, while the Chinese monetary system is quantity-constrained.
Chinese investors may be misled by domestic phenomena and misunderstand some phenomena in the US monetary system. Therefore, we need to go back to the basics and compare the differences between the two systems.
The above image is a simplified diagram of the price-guided monetary system, which is slightly different from reality (e.g., the difference between the interest rates on demand deposits and the federal funds rate), but it captures the essence.
In this system, the lever of the Federal Reserve is not the reserve size H, but the interest rate on demand deposits R. Therefore, the expansion and contraction of the financial system depend on two factors:
- The level of interest rates on demand deposits.
- The strength of the real economy.
In other words, whether the financial system expands depends on the relative level of interest rates to the real economy.
In extreme cases, when the policy interest rate is low at 0% and the real economy is unwilling to borrow, the entire system falls into a liquidity trap and requires the Federal Reserve to directly purchase assets and expand the reserve size H, which is what we often refer to as quantitative easing (QE).
In contrast, the Chinese monetary system focuses on quantity constraints, with the supply and demand of reserves at its core, and does not regulate the interest rates on demand deposits much. Therefore, this system does not have the concept of a liquidity trap, but rather a "liquidity dam". When the economy is not doing well, we will see continuous declines in funding rates and social financing growth.
Overall, there is a big difference between the two systems, and caution is needed when using these concepts.
The Impact of Economic Recession on Liquidity
In the price-guided monetary system, the relative size of the economy and the policy interest rate is what really matters.
The scenario that is easier for us to understand is when the policy interest rate increases, the financial system contracts, and the yield on 10-year government bonds rises.
The scenario that is harder to understand is when the economy enters a recession, the financial system contracts, and the yield on 10-year government bonds also rises.
Currently, we are likely in the latter scenario, as the federal funds rate is very high at 5.25%-5.5%.
As shown in the graph below, when the economic strength is above a certain threshold, the condition of demand deposits in the system is normal. Once the economic strength falls below the threshold, the supply of liquidity will become a problem.
Recently, not only have US long-term bonds fallen, but also the prices of US dollar gold and oil, which cannot be explained by simple fundamental factors. This is an exceptional liquidity shock to the US dollar.
The Substitution Effect and the Total Effect
The reason we like to link economic prosperity with bond yields is because we focus on the substitution effect:
- When the economy is booming, risk assets rise and bond prices fall, leading to an increase in bond yields.
- Conversely, when risk assets fall, bond prices rise, leading to a decrease in bond yields.
However, the relationship between the stock market and the bond market has both a substitution relationship and a common cause relationship.
Generally, when the Federal Reserve raises interest rates, we understand the problem from the perspective of the total effect, and both stocks and bonds will decline together.
Ironically, when the economy is doing well, we tend to understand the problem from the perspective of the substitution effect, with stocks rising and bonds falling.
However, the price-guided monetary system implies a very important logic: when the economy is doing well, the level of demand deposits in the system increases; conversely, it decreases.
In other words, the real economy will bring both substitution effects and total effects.
Therefore, why do we often overlook the total effect of the real economy? This is because regardless of whether the economy is booming or declining, the substitution effect is more significant.
-
During the economic upswing phase:
When the economy continues to grow, risk appetite gradually increases. Although liquidity in the financial system is expanding, risk assets absorb more liquidity. From the perspective of bonds, the substitution effect is unfavorable, and the total effect is favorable, but the substitution effect outweighs the total effect. -
During the economic downturn phase:
When the economy continues to decline, risk appetite keeps falling. Although liquidity in the financial system is contracting, risk assets release more liquidity. From the perspective of bonds, the substitution effect is favorable, and the total effect is unfavorable, but the substitution effect outweighs the total effect.
In addition, during this phase, the Federal Reserve generally lowers interest rates to offset the contraction in the total effect.
Awkward Turning Point Phase
Furthermore, we can outline the following logical diagram:
The actions of the Federal Reserve will have a total effect; the real economy will bring both substitution effects and total effects.
Currently, the entire system is at a turning point, which is a very awkward stage:
- The total effect generated by the Federal Reserve is negative.
- The total effect generated by the real economy has changed from positive to negative.
The combination of these two negative total effects leads to a stage of simultaneous decline in stocks and bonds, and assets other than the US dollar will also experience varying degrees of decline.
From Inconsistent Space to Inconsistent Time
In the article "Global Dollar System and Its Usage Methods," we discussed the split between onshore and offshore dollars.
The tightening of offshore dollars mainly comes from the inconsistency in economic strength in space: the onshore economy is strong, while the offshore economy is weak.
This article shifts the focus to the inconsistency in time. The US domestic economy has already weakened, but the federal funds rate remains rigid, and the Federal Reserve maintains a strong stance on the "how long" question.
If the Federal Reserve continues to maintain a hawkish attitude, the inevitable result will be further contraction of liquidity, leading to a larger decline in risk assets.
In other words, a larger decline in US stocks will lead to a shift in the bond market, which in turn will force the Federal Reserve to change its stance.
Gradually Drying Up US Dollar Liquidity
In summary, we understand the sequence of the drying up of US dollar liquidity: first, offshore dollars, and then onshore dollars.
When onshore dollars become depleted, the yield on 10-year US Treasury bonds will accelerate its rise, the US dollar index will soar, and other US dollar assets will also experience varying degrees of decline.
Interestingly, this framework embeds a paradoxical inference: the reason why the yield on 10-year US Treasury bonds is rising rapidly is because the US economy has fallen below the turning point.
The above deduction is based on deductive reasoning and is a non-conventional explanation. Its explanatory power still needs to be tested in practice.
If the US economy really enters a recession in the future, we need to pay attention to confirming this wave of liquidity shocks before the recession.
Because the price-guided monetary system implies the repeatability of this shock: it is not the rise in the yield on 10-year US Treasury bonds that brings about the recession, but rather the recession that brings about the rise in the yield on 10-year US Treasury bonds.
In addition, we will have a more beautiful explanation for the steepening of the yield curve before the arrival of a recession: the recession will bring about the extreme contraction of the US dollar, and the contraction of the US dollar will lead to the steepening of the yield curve.
Note: Data from Wind, images from the internet