Submitted by Taps Coogan on the 3rd of September 2019 to The Sounding Line.

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Luke Gromen, founder and president of Forest for the Trees, recently spoke with MACRO Voices’ Erik Townstead about the fact that currency hedged US treasury bond yields have been negative since October 2018. Mr. Gromen believes that the combination of rising US dollar hedging costs and increasing treasury issuance may lead to a dollar liquidity crisis that will force the Fed to start monetizing US fiscal deficits permanently.

Some excerpts from Luke Gromen:

“Up until October of last year, …US banks were growing their US swap books endlessly which basically offers attractively priced insurance on a fall in the dollar that allowed the global private sector to continue to buy treasuries, totally hedge the dollar-risk out of those treasuries, and still make a positive nominal carry. So banks’ FX swap books had to grow endlessly to do this… for two reasons. The first is because US deficits are growing endlessly and two…, because global central banks stopped growing their holdings of treasuries in the third quarter of 2014. And so basically, what began happening last fall is akin to what happened to subprime mortgage insurance in the mid-2000s with credit default swaps. Back then, banks were selling cheap credit default swaps to anyone with an ISDA derivative license that wanted to buy that insurance and that was allowing people that probably should not have been taking out subprime mortgages to take out subprime mortgages… This continued until roughly 2007 when Wall Street banks famously stopped selling credit default swaps and turned buyers of those credit default swaps themselves once they realized what was happening in the housing market…”

“(This time) US banks had been selling ‘dollar insurance’ (FX swaps) to anyone that wanted to buy dollar insurance. The end result being that the US banks doing this up until late 2018, had allowed the US government to borrow an extra $14 trillion or so, with the currency risk assumed by the foreigners lending this money principally covered by the US banking system, which had underestimated how dangerous this could be… What happened last October was that FX swap insurance on the dollar effectively when ‘no-offer’ and, from that point on, the foreign private sector either had to take a significantly negative yield on treasuries after paying FX hedging costs, or leave the treasury positions unhedged for dollar risk, or… take their money out of treasuries…”

“The US fiscal problems are getting quite acute and the symptom is what global sovereign debt yeilds are doing… As long as deficits keep rising and US banks aren’t growing their FX swap books enough, the cost to hedge dollar should keep rising. So, FX hedged treasury yields should keep getting more negative, which means that foreign sovereign yields should keep getting more and more negative…”

“What dollar insurance going ‘no-offer’ will ensure is that US fiscal deficits will force the Fed to effectively monetize US deficits going forward, permanently, which we think will force a significant change in the structure of the dollar’s reserves status that we think is being hinted at pretty strongly by record central bank gold buying…”

There is much more to the interview, so enjoy it above.

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