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On the Verge of a Liquidity Event
BY DEATH TAXES AND QE
The upcoming reserve drain will flow throughout dollar funding markets, blowing up the cash-futures basis trade and creating safe-haven positioning that spikes the dollar’s FX.
A soaring dollar in FX terms and an unsteady Treasury market would contradict protectionist goals of the incoming Trump administration and stability goals of to the Fed, respectively, giving both a shared incentive to weaken it. The most direct and impactful way in which officials can weaken the dollar and restore stability to the Treasury market is by encouraging a new end investor to narrow interest rate differentials between foreign bonds and U.S. Treasuries.
The 'new' end investor will most likely be commercial banks armed with balance sheet relief for Treasuries. But that regulatory change will not come until the situation absolutely demands it – what I call "the dealer's Armageddon", as unfolded in March 2020.
Here, the mechanics of the reserve drain leading to a basis trade unwind, and how this flows through the dollar system, from Treasuries to stocks to FX to gold, are analyzed in much greater detail than they were last month.