The algos and carbon fx traders are probably gauging right now whether the Dollar Milkshake trade is over, in view of the Fed’s patience to pull the reins of its normalization policy
So, firstly let’s zero in on the Dollar Milkshake trade theory, no doubt a current hot topic in the forex market with an average daily turnover of approximately 5.35 trillion USD a day.
The crux of the Dollar Milkshake theory put forward by Brent Johnson CEO of Santiago Capital is based on the dollar strengthening and the fallout that could have on global markets
Dollar Milkshake theory sounds yummy and jolly but do not be fooled, “this is a story that ends very, very badly,” said Brent Johnson in his interview.
So Dollar Milkshake theory predicts a bull market in USD, which has been underway for some time, but it comes with a caveat.
A big “milkshake of liquidity” has been created by the global central banks with their unprecedented monetary easing policy which entailed injecting $20 trillion in Dollars, EURO, Yen into the global economy since the financial crisis of 2008.
Dollar Milkshake theory views central bank liquidity as the milkshake and when Fed’s policy transitions from easing to tightening they are exchanging a metaphoric syringe for a big straw sucking liquidity from global markets
Despite all the talk about global de-dollarisation the USD currently facilitates a significant proportion of global trade. Moreover, the entire investment world currently depends on the dollar and its money flow.
Put simply, global loans made in USD need to be paid back with interest in USD.
Dollar Milkshake theory explains a USD rally in terms of market dynamics of demand for dollars exceeding their supply
When the Fed, the world’s central bank by default, raises base rates and does quantitative tightening, another way for saying the central bank becomes a seller of assets, that limits the global supply of dollars.
Meanwhile, foreign countries and companies “need north of a trillion USD just to make interest payments on dollar-based debt,” according to Brent Johnson. Moreover, to add to this USD liquidity drought the US Treasury is issuing dollar-denominated bonds to obtain funding for US infrastructure projects.
So the Dollar Milkshake theory supports the USD bull market argument going forward.
Is Dollar Milkshake trade now exhausted in the current financial climate where the Fed has doubled down on its dovish stance?
Another school of thought argues that Dollar Milkshake trade is done, that the Fed through its suspension of normalization policy has for the foreseeable future abandoned quantitative tightening (QT) and rate hikes. In other words, the Fed has withdrawn its syringes and could soon be adding liquidity (milk) to the Dollar Milkshake with maybe even a QE4 asset purchase program.
There are those who disagree with the Dollar Milkshake theory and see the end of the USD bull market
The dollar bears cite that the Fed is done with raising rates and QT and thereby limiting the global supply of dollars.
Moreover, what counts is the net liquidity conditions provided by the major western aligned central banks (BoJ, BoE, ECB). So even if the Fed were to continue tightening the other central banks could counteract that with more liquidity.
Dollar Milkshake theory argues that what counts in a global financially connected world is where the capital flows and not so much which central bank around the world is providing the liquidity.
For example,the ECB could continue with its multi-billion dollar asset purchase program but that liquidity could also flows into US Treasury 10 year yields. Why?
Investors might fear the risk of a growing recession and could calculate that political risk in Europe right now is too high. So in this scenario, the Dollar Milkshake still has a straw. The US yield curve has inverted again as investors rotate out of stocks into the 10-year treasuries, which many cite as the market flashing recession on the horizon. But as global demand for 10Y treasuries, considered a safe haven asset goes hot, so too is the demand for USD and that also implies that the Dollar Milkshake straw is drawing global USD from global finance.
Dollar Milkshake theory is also another way of explaining the taper tantrum of 2013
The surge US yields attracted funds out of emerging markets and into the USD.
Emerging markets with dollar dominated debts are at most risk from the Dollar Milkshake theory which suggests a depreciating USD.
The most recent signs of the problem unfolding have been seen in Argentina, Turkey, and China.
The Dollar Milkshake theory is based on the USD being perceived as a safe haven
As a crisis situations become larger and less contained the dollar (and precious metals) will act more and more as a safe haven and suck up further capital flows from across the globe.
In short, Dollar Milkshake trade could still have mileage
The USD could continue to appreciate which could also create an EM loan default crisis. As USD loans turn bad liquidity is evaporated from the system which could also limits the dollar supply further.
So who benefits from the Dollar Milkshake theory?
Capitalism smiles on those with the means and foresight of investing in value assets at a bargain. So when the dollar appreciates global assets for those holding USD get cheaper. If the EU disintegrates and it takes the Euro down with it Europe will be recolonized. But this time it will not be American tanks rolling in instead it will be American dollars.
The Dollar Milkshake theory could be a disaster for globalism but it could also be a boon for USD hegemony and Americanism.