How bad is the dollar squeeze?
This has not been your regular dollar squeeze. Over the last month, the cost of obtaining US dollars offshore has soared to levels last seen in “crisis” periods, yet bank equities have rallied the most in six years. Rather than a new crisis unfolding, we seem to be transitioning to a macro environment where dollars are structurally scarce. This will be challenging for weak link economies, as shown last week by adverse market moves in Brazil and Mexico, but need not be a disaster for the better managed.
US dollar funding has been getting tighter since 2014, but the trend has intensified since Donald Trump’s surprise presidential win as shown by widening spreads for crosscurrency basis swaps. A yen-based investor looking to borrow dollars for one year funded by a USD/JPY swap must now pay 77.5bp above the US dollar Libor rate, the most since the series started in 1997. Similarly, a euro-based investor must pay the most since the eurozone crisis in 2011-12 for a similar EUR/USD swap (see chart). The funding cost in emerging Asia, which had held fairly steady over the last two years, has risen over the last month on portfolio outflows.
Typically, CCS spreads widen on worries about counterparty risk, as manifested by credit default swaps for banks blowing out. The fact that CCS spreads have widened during a period of generally benign financial conditions points to a deeper set of distortions, namely:
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-
Increased demand
Reduced
liquidity:
for US
dollar
funding:
Given divergent monetary policies between the US (tightening) and Europe and Japan (still easing), investors have chased higher US dollar yields and tapped the CCS market in order to get low-cost funding, or currency hedging. US corporates have been big issuers of euro denominated bonds with proceeds shifted back into dollars through foreign exchange swaps. Both of these “carry trades” boosted demand for dollar funding that had to be fulfilled offshore. Still, while such distortions may explain temporary rises in the CCS swap rate, the market should, in the absence of underlying stress, self-correct. The fact that banks are doing much less normal arbitrage by borrowing at the (lower) Libor rate and lending in the CCS market brings us to the next point.
The Bank for International Settlements puts higher CCS-US money market spreads down to banks’ reduced market-making activity, as seen in other corners of the capital markets. Diminished CCS market liquidity coincided with new regulations covering leverage ratios and restrictions over banks taking proprietary positions. Hence, while post-crisis regulation aimed to curb systemic risk, it has amplified the global cost of US dollar funding during a very mild supply squeeze.
Even if the world does not face a dollar supply crunch, the flow of dollars reaching markets has slowed as shown by a decline in global foreign exchange reserves. Meanwhile, US money market reforms have made it harder for non-US banks to access unsecured funding in the onshore market. Looking ahead, a repatriation of US corporate profits held offshore will further shrink dollar supply.
The good news is that these problems mostly come down to liquidity and so should be manageable by central banks given the swap lines between the Federal Reserve and other key central banks. Moreover, as global banks are not running naked dollar shorts, they have the option to wind down positions by calling in US dollar loans (or cutting their hedging services). The bad news, at least in Europe, is that any resumption of sovereign debt sustainability fears could end up as a self-fulling prophecy as US dollar shortages heighten risk aversion and trigger a cycle of precautionary cash hoarding. In emerging markets, the concern is that dollar scarcity spurs more deleveraging and so disappointing
- Reduced dollar supply:
growth. Still, as Anatole Kaletsky will argue, EMs should be able to ride this out.
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