If you can work your way through this, just trying to get the ‘sense’ of it, you will see the Fed apparently has dug itself a hole, one they can’t get out of. The timeline is longer than I like, but then, anything can happen . . . ~J
The last time the world was sliding into a US dollar shortage as rapidly as it is right now, was following the collapse of Lehman Brothers in 2008. The response by the Fed: the issuance of an unprecedented amount of FX liquidity lines in the form of swaps to foreign Central Banks. The “swapped” amount went from practically zero to a peak of $582 billion on December 10, 2008.
The USD shortage back, and the Fed’s subsequent response, was the topic of one of our most read articles of mid-2009, “How The Federal Reserve Bailed Out The World.”
As we discussed back then, this systemic dollar shortage was primarily the result of imbalanced FX funding at the global commercial banks, arising from first Japanese, and then European banks’ abuse of a USD-denominated asset-liability mismatch, in which the dollar being the funding currency of choice, resulted in a massive matched synthetic “Dollar short” on the books of commercial bank desks around the globe: a shortage which in the aftermath of the Lehman failure manifested itself in what was the largest global USD margin call in history. This is how the BIS described first the mechanics of the shortage:
The accumulation of US dollar assets saddled banks with significant funding requirements, which they scrambled to meet during the crisis, particularly in the weeks following the Lehman bankruptcy. To better understand these financing needs, we break down banks’ assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another. We find that, since 2000, the Japanese and the major European banking systems took on increasingly large net (assets minus liabilities) on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of net foreign currency positions exposed these banks to foreign currency funding risk, or the risk that their funding positions (FX swaps) could not be rolled over.
… And then the subsequent global public response:
The severity of the US dollar shortage among banks outside the United States called for an international policy response. While European central banks adopted measures to alleviate banks’ funding pressures in their domestic currencies, they could not provide sufficient US dollar liquidity. Thus they entered into temporary reciprocal currency arrangements (swap lines) with the Federal Reserve in order to channel US dollars to banks in their respective jurisdictions (Figure 7). Swap lines with the ECB and the Swiss National Bank were announced as early as December 2007. Following the failure of Lehman Brothers in September 2008, however, the existing swap lines were doubled in size, and new lines were arranged with the Bank of Canada, the Bank of England and the Bank of Japan, bringing the swap lines total to $247 billion. As the funding disruptions spread to banks around the world, swap arrangements were extended across continents to central banks in Australia and New Zealand, Scandinavia, and several countries in Asia and Latin America, forming a global network (Figure 7). Various central banks also entered regional swap arrangements to distribute their respective currencies across borders.
The amount of the implied dollar short was also calculated by the BIS.
The major European banks’ US dollar funding gap had reached $1.0–1.2 trillion by mid-2007. Until the onset of the crisis, European banks had met this need by tapping the interbank market ($432 billion) and by borrowing from central banks ($386 billion), and used FX swaps ($315 billion) to convert (primarily) domestic currency funding into dollars. If we assume that these banks’ liabilities to money market funds (roughly $1 trillion, Baba et al (2009)) are also short-term liabilities, then the estimate of their US dollar funding gap in mid-2007 would be $2.0–2.2 trillion. Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion (Figure 5, bottom right panel).
One thing to keep in mind as reading the above (and the linked article as a refresher), is that the massive USD synthetic short, and resulting margin call, was entirely due to the actions of commercial banks, with central banks having to step in subsequently and bail them out using any and every (such as FX swaps) mechanism possible.
* * *
Why do we bring all of this up now, nearly 6 years later? Because, as JPM observed over the weekend while looking at the dollar fx basis, the shortage in dollar funding is back and is accelerating at pace not seen since the Lehman collapse.
The good news: said shortage is not quite as acute yet as it was in either 2008/2009 or on November 30 2011 (recall “Here Comes The Global, US-Funded Liquidity Bail Out“) when just as Europe was again on the verge of collapse, the Fed re-upped the ante on its global swap lines when it pushed the swap rate from OIS+100 bps to OIS+50 bps.
The bad news: at the current pace of dollar funding needs, it is almost certain that the tumble in the dollar fx basis will accelerate until it hits its practical minimum of – 50 bps, which is the floor as per the Fed-ECB swap line.
But the real news is that unlike the last time, when the global USD funding shortage was entirely the doing of commercial banks, this time it is the central banks’ own actions that have led to this global currency funding mismatch – a mismatch that unlike 2008, and 2011, can not be simply resolved by further central bank intervention which happen to be precisely the reason for the mismatch in the first place.
In other words, central banks have managed to corner themselves in yet another policy cul-de-sac, six years after they did everything in their power to undo the last one.
Here is how JPM’s Nikolaos Panigirtzoglou frames the problem:
The decline in the cross currency swap basis across most USD pairs in recent months is raising questions regarding a shortage in dollar funding. The fx basis reflects the relative supply and demand for dollar vs. foreign currency funds and a very negative basis currently points to relative shortage of USD funding or relative abundance of funding in other currencies. Such supply and demand imbalances can create big shifts in the fx basis away from its actuarial value of zero. Figure 1 shows that the dollar fx basis weighted across eight DM and EM currencies, declined significantly over the past year to its lowest level since mid 2013, although it remains well above the lows seen during the depths of the Lehman or the Euro debt crisis.
It does indeed, for now, however read on for why the current basis reading just shy of -20 bps will almost certainly accelerate until and unless there is a dramatic convergence in the policies of the Fed and the other “developed world” central banks.
First, what are currency and fx swaps, and why does anyone care? “Cross currency swaps and FX swaps encompass similar structures which allow investors to raise funds in a particular currency, e.g. the dollar from other funding currencies such as the euro. For example an institution which has dollar funding needs can raise euros in euro funding markets and convert the proceeds into dollar funding obligations via an FX swap. The only difference between cross currency swaps and FX swaps is that the former involves the exchange of floating rates during the contract term. Since a cross currency swap involves the exchange of two floating currencies, the two legs of the swap should be valued at par and thus the basis should be theoretically zero. But in periods when perceptions about credit risk or supply and demand imbalances in funding markets make the demand for one currency (e.g. the dollar) high vs. another currency (e.g. the euro), then the basis can be negative as a substantial premium is needed to convince an investor to exchange dollars against a foreign currency, i.e. to enter a swap where he receives USD Libor flat, an investor will want to pay Euribor minus a spread (because the basis is negative).”
One read of a substantial divergence from par in the fx basis is that there may be substantial counterparty concerns within the banking system – this was main reinforcing mechanism for the first basis blow out of the basis back in 2008.
Both cross currency and FX swaps are subjected to counterparty and credit risk by a lot more than interest rate swaps due to the exchange of notional amounts. As such the pricing of these contracts is affected by perceptions about the creditworthiness of the banking system. The Japanese banking crisis of the 1990s caused a structurally negative basis in USD/JPY cross currency swaps. Similarly the European debt crisis of 2010/2012 was associated with a sustained period of very negative basis in USD/EUR cross currency swaps.
As noted above, the fundamental reasons for the USD shortage then vs now are vastly different. Back then, financial globalization meant
that “Japanese banks had accumulated a large amount of dollar assets during the 1980s and 1990s. Similarly European banks accumulating a large amount of dollar assets during 2000s created structural US dollar funding needs. The Japanese banking crisis of 1990s made Japanese banks less creditworthy in dollar funding markets and they had to pay a premium to convert yen funding into dollar funding. Similarly the Euro debt crisis created a banking crisis making Euro area banks less worthy from a counterparty/credit risk point of view in dollar funding markets. As dollar funding markets including fx swap markets dried up, these funding needs took the form of an acute dollar shortage.“
And as further noted above, while there is no banking crisis (at this moment) unlike virtually every other year in the post-Lehman collapse as commercial banks are flooded in global central bank liquidity (now that central banks are set to inject more liquidity in 2015 than in any prior year, 2008 and 20099 included) the catalyst for the current shortage are central banks themselves:
Given the absence of a banking crisis currently, what is causing negative basis? The answer is monetary policy divergence. The ECB’s and BoJ’s QE coupled with a chorus of rate cuts across DM and EM central banks has created an imbalance between supply and demand across funding markets. Funding conditions have become a lot easier outside the US with QE-driven liquidity injections and rate cuts raising the supply of euro and other currency funding vs. dollar funding. This divergence manifested itself as one-sided order flow in cross currency swap markets causing a decline in the basis.
Who would have ever thought that a stingy Fed could be sowing the seeds of the next financial crisis (don’t answer that rhetorical question).
For those who are curious about where this mismatch is manifesting itself in practical terms, look no further than the amount of USD (expensive) vs non-USD (i.e., EUR, i.e., very cheap thanks to NIRP) denominated cross-border debt issuance:
Do we see these funding imbalances in debt issuance? The answer is yes if one looks at cross border corporate issuance. Figure 2 shows how EUR denominated corporate bond issuance by non-European issuers (Reverse Yankee issuance) spiked this year as percentage of total EUR denominated corporate issuance. Similarly Figure 3 shows how Yankee issuance, the share of USD denominated corporate issuance by non-US companies, declined sharply this year. In other words, cross border issuance trends are consistent with higher supply of EUR funding vs. USD funding. We get a similar picture in value terms. Reverse Yankee issuance totaled €47bn YTD which annualized is twice as big as last year’s pace. Yankee issuance totaled $41bn YTD which represents a decline of more than 30% from last year’s annualized pace.
Which makes sense: why would US multinationals, already hurting by the surge in the USD on their income statement, also suffer this move on the balance sheet abnd pay about 50 bps more for the same piece of paper issued in Europe? They won’t, of course, however in the process they will hedge fx, and push the basis even further into negative territory. JPM explains:
Does this cross border issuance have a currency impact? It depends. For example, if a US company issues in EUR and swaps back into USD to effectively achieve cheaper synthetic USD funding rather than issuing directly in US dollar funding markets, the transaction has no currency impact. This synthetic USD funding especially attractive right now as credit spreads over swaps are much tighter in Europe than in the US by around 40bp-50bp for A-rated corporate currently in intermediate maturities, which more than offsets the negative fx basis. This means there is a significant yield advantage for US companies using synthetic USD funding (i.e. issuing in EUR and swapping back into USD rather than issuing in USD directly). In theory, the USD-EUR credit spread difference of Figure 4 suggests that the fx basis has room to widen by another 20bp, i.e. to decline to -50bp before the yield advantage of synthetic USD funding disappears. For the EURUSD, the basis cannot go below -50bp as this is the floor implied by the ECB’s FX swap line with the Fed.
And there you have it: all else equal, there is at least enough downside to push the fx basis as far negative at -50 bps: this would make the USD shortage the most acute it has ever been, at least as calculated by this key metric! And since this is essentially a risk-free arb for credit issuers, and since there are many more stock buybacks that demand credit funding, one can be certain that the current fx basis print around – 20 bps will most certainly accelerate to a level never before seen, a level which would also hint that something is very broken with the financial system and/or that transatlantic counterparty risk has never been greater.
Unlike us, JPM hedges modestly in its forecast where the basis will end up:
Whether the above YTD trends continue forward is a difficult call to make. The widening of USD vs. EUR credit spreads shown in Figure 4 has the propensity to sustain the strength of Reverse Yankee issuance putting more downward pressure on the basis. On the other hand, this potential downward pressure on the basis should be offset to some extent by Yankee issuance the attractiveness of which increases the more negative the basis becomes.
In all, different to previous episodes of dollar funding shortage such as the ones experienced during the Lehman crisis or during the euro debt crisis, the current one is not driven by banks. It is rather driven by the monetary policy divergence between the US and the rest of the world. This divergence appears to have created an imbalance in funding markets and a shortage in dollar funding. It is important to monitor how this dollar funding shortage and issuance patterns evolve over time even if the currency implications are uncertain.
And to think the Fed’s cheerleaders couldn’t hold their praise for the ECB’s NIRP (as first defined on these pages) policy. Because little did they know that behind the scenes the divergence in Fed and “rest of the world” policy action is leading to two things: i) the fastest emergence of a dollar shortage since Lehman and ii) a shortage which will be arbed to a level not seen since Lehman, and one which assures that over the coming next few months, many will be scratching their heads as to whether there is something far more broken with the financial system than merely an arbed way by US corporations to issue cheaper (hedged) debt in Europe thanks to Europe’s NIRP policies.
If and when the market finally does notice this gaping dollar shortage (as is usually the case with the mandatory 3-6 month delay), watch as the Fed will once again scramble to flood the world with USD FX swap lines in yet another desperate attempt to prevent the global dollar margin call from crushing a matched synthetic dollar short which according to some estimates has risen as high as $10 trillion.
Until then, just keep an eye on the Fed’s weekly swap line usage, because if the above is correct, it is only a matter of time before they are put to full use once again.
Finally what assures they will be put to use, is that this time the divergence is the direct result of the Fed’s actions, and its insistence that despite what is shaping up to be a 1% GDP quarter, that it has to hike rates. Well, as JPM just warned it in not so many words, be very careful what you wish for, and what you end up getting in your desire to telegraph just how “strong” the US economy is.