The Dollar shortage of 2018 and maybe 19

Today we return to a topic which has been regularly in the headlines in 2018. We started the year with the US administration that looking like it was talking the US Dollar lower in line with its America First policy. Back on the 23rd of January we were mulling this.

“Obviously a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin told reporters in Davos. The currency’s short term value is “not a concern of ours at all,” he said.

However as the year has gone by we have found ourselves mulling what the US Treasury Secretary said next.

“Longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and will continue to be the primary currency in terms of the reserve currency,” he said.

If we look at matters from the perspective of the Euro then the 1.20 of the opening of 2018 was fairly quickly replaced by 1.25. But since then the US Dollar has rallied and has moved to 1.15. Some of that has been in the past few days as it has moved from 1.18 to 1.15. That recent pattern has been repeated across most currencies and at 114 the US Dollar us now up on the year against the Yen as well. The UK Pound has suffered this year from a combination of the Brexit process and the machinations of the unreliable boyfriend but it too has been falling recently against the US Dollar to below US $1.30 whilst holding station with other currencies.

Year end problems

The currency moves above are being at least partly driven by this from Reuters.

As the Fed raises interest rates and reduces its balance sheet, and the dollar and U.S. bond yields move up, overseas investors are finding it increasingly difficult and costly to access dollars. That much is obvious. What’s perhaps more surprising – and potentially worrying – is just how expensive and scarce those dollars are becoming.

So with US Dollar scarce it seems that some have been dipping their toes into the spot currency markets as a hedge. This is because other avenues have become more expensive.

Until this week the cross-currency basis market, one of the most closely-watched measures of broad dollar demand, liquidity and funding, had showed no sign of stress. Demand for offshore dollars was being met easily and at comfortable prices.But the basis widened sharply on Thursday, the day after the Fed raised rates for the eighth time this cycle and signalled it fully intends to carry on hiking. In euros, it was the biggest one-day widening since the Great Financial Crisis.

So last week there was a type of double whammy of which the first part came from the US Federal Reserve.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2 to 2-1/4 percent.

So US official interest-rates have risen but something else has been happening.

Three-month dollar funding costs are currently running around 2.50 pct. Not high by historical standards and, on the face of it, surely manageable for most borrowers. But it is heading higher, and the availability of dollars is shrinking.

So as you can see a premium is being paid on official interest-rates. So we have higher interest-rates and a more expensive currency. We know that in spite of the official rhetoric that various countries are moving away from dollar use the trend has been the other way. From Reuters again.

All this at a time when the world’s reliance on the dollar has never been greater. Its dominance as the international funding currency has grown rapidly since the 2008 crisis, especially for emerging market borrowers.

Dollar credit to the non-bank sector outside the United States stood at 14 percent of global GDP at the end of March this year, up from 9.5 pct at the end of 2007, according to the Bank for International Settlements.

Dollar lending to non-bank emerging markets has more than doubled to around $3.7 trillion since the crisis and a similar amount has been borrowed through currency swaps.

Regular readers will recall that back on the 25th of September I took a look at the potential for a US Dollar shortage as we face a new era.

The question to my mind going forwards is will we see a reversal in the QT or Quantitative Tightening era? The supply of US Dollars is now being reduced by it and we wait to see what the consequences are.

Indian problems

The largest country in the sub-continent has been feeling the squeeze in several ways recently. One has been the move away from emerging market economies and currencies. Another has been the impact of the fact that India is a large oil importer and the price of crude oil has been rising making the problem worse. This morning’s move through US $86 for a barrel of Brent Crude Oil may fade away but over the past year we have seen a rise of around 53%. For the Indian Rupee this has been something of what might be called a perfect storm as it has found itself under pressure from different avenues at the same time. Back on the 16th of August I looked at the Indian crude oil dependency and since then the metric have got worse. The price of oil has risen further and partly in response to that the Rupee has weakened from 70 to the US Dollar which was a record low at the time to 74 today.

Accordingly I noted this earlier from Business Standard.

The Reserve Bank of India (RBI) on Wednesday allowed oil-marketing companies (OMCs) to raise dollars directly from overseas markets without a need for hedging.

In a post-market notification, the RBI said the minimum maturity profile of the borrowings should be three years and five years, and the overall cap under the scheme would be $10 billion. The central bank relaxed criteria for this.

It gives us a guide to the scale of the Indian problem.

The oil-swap facility was much anticipated in the market, as that would have taken the pressure away from the market substantially. Annually, the dollar demand on oil count is $120 billion, or about $500 million, on a daily basis for every working day.

And the driving factor was a lack of US Dollar liquidity

The RBI announcements on liquidity are more focused towards providing relief to the NBFCs (non-banking financial companies) and banks, rather than cooling of the rupee in the FX markets,

Let us move on after noting that the Reserve Bank of India may have had a busy day.

Currency dealers say the RBI intervened lightly in the market.

Comment

Overnight we have seen news regarding a possible impact on the US treasury bond market which is for holders a source of US Dollars. From Janus Henderson US.

Euroland, Japanese previous buyers of 10yr Treasuries have been priced out of market due to changes in hedge costs.  For Insurance companies in Germany / Japan for instance, U.S. Treasuries yield only -.10% / -.01%. Lack of foreign buying at these levels likely leading to lower Treasury prices.

This has impacted the US treasury bond market overnight and prices have fallen and yields risen. The ten-year Treasury Note now yields 3.21% instead of 3.15%. That does not make Bill Gross right ( he was famously wrong about UK Gilts being on a bed of nitroglycerine ) as the line of least resistance for markets would be to mark them lower in price terms and see what happens. Try and panic some into selling.

As to the yield issue which may seem odd the problem is that the cost of currency hedging your position is such that you lose the yield. Thus relatively high yielding US Treasuries end up being similar to Japanese Government Bonds and German Bunds.

As ever when there are squeezes on it is not so much the overall position which is a danger but the flows. For example India’s pol problem is good news for oil exporters but if they are not recycling their dollars then there is an imbalance. I guess of the sort which is why this temporary feature became permanent.

In November 2011, the Federal Reserve announced that it had authorized temporary foreign-currency liquidity swap lines with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank.

Me on Core Finance TV

 

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Is there a shortage of US Dollars and if so why?

At the moment we are seeing quite a few trends combined which look as though they are returning us to a position where there is a shortage of US Dollars. This is troubling as this was an issue in the genesis of the credit crunch as back then it affected banks and particularly European and Japanese ones. It seems odd as the foreign exchange market is very liquid but maybe it is not liquid enough or at least at the right price. Back in March Pictet Bank provided something of an explainer.

The problem is a spike in the differential between LIBOR and the Overnight Index Swap, or the premium over the risk-free rate non-US banks pay to borrow dollars outside of the US.

The spread has risen to 42 basis points, the highest since February 2012, and up from 25 basis points at the start of last month and just 10 basis points in November.

While the rise does not pose a systemic risk, it has nevertheless raised the cost, and reduced the availability, of dollar-denominated loans for non-US banks by a considerable margin and in short space of time.

It is pretty much back to that level (43) after going above 60 and just for clarity that is 0.6%. Here is the first lesson  of this saga in that in our present world some interest-rates do not seem to have much impact at all as for example I did warn on the third of this month that a rise in Argentinian ones would backfire. Some 9.75% higher later I guess my point has been made for me. However here we have a 0.6% or so at the peak looks in terms of Carly Rae Jepson that it “really,really,really,really” matters. This appears to be driven by two factors the first is that it affects the “precious” otherwise known as the banks and is in US Dollars. Of course the official story is rather different as the excerpt below from the May Inflation Report of the Bank of England shows.

In the years following the crisis, funding spreads narrowed as banks repaired their balance sheets and became more resilient.

I am resilient, we are resilient , it has unexpectedly collapsed ….

US Dollar

This has been a factor as we note that recently the US Dollar has been what we might call King Dollar again. If we use the US Dollar Index or DXY for this we see that it has rallied four points since mid April from over 89 to over 93 now. The bigger turn came at the opening of June 2014 when it has dipped below 80. So the price of the US Dollar has risen too over this phase. Whilst the DXY is now out of date in trade terms as for example the Chinese Yuan is missing it does a job for this sort of analysis as the Yen and Euro are there.

US Interest-Rates and Yields

This has been a case of singing along with Jackie Wilson.

You know your love (your love keeps lifting me)
Keep on lifting (love keeps lifting me)
Higher (lifting me)
Higher and higher (higher

The US Federal Reserve has increased its official interest-rate to between 1.5% and 1.75% and nearly as importantly has been raising the rhetoric about there being more (3/4) increases this year. I am not convinced by this but if we look around markets seem to be accepting it perhaps on the grounds that unlike other central banks the Fed has at least been reasonably consistent.

Also there have been rises in bond yields with the media concentrating on 3% for the ten-year Treasury Note and then 3.1%. But for this purpose more significant is what has taken place at the shorter maturities. The chart below gives us a handle on what has been taking place there.

Let me be clear here this is a financial markets thing rather than a real economy thing but these do have a way of leaking across and tripping up the unwary. Adding to this we are seeing real world effects too as I note this from Reuters.

Interest rates on U.S. 30-year fixed-rate mortgages rose to the highest in seven years as a bond market selloff this week propelled 10-year yields to the highest since July 2011, Freddie Mac said on Thursday………Thirty-year mortgage rates averaged 4.61 percent in the week ended May 17, matching the level last seen in May 2011.

Of course they affect the banks from another route.

Quantitative Tightening

One way that the supply of US Dollars is being reduced is quite basic as the US Federal Reserve has set out to do that explicitly. From a balance sheet which just passed US $ 4.5 Trillion we now see that it has fallen to US $4.36 trillion which put like that may not seem a lot but that is US $140 billion or so. The pace is also picking up a bit so in terms of narrow money or what central bankers have loved to call “high-powered money” there is less of it to go around from this source at any rate.

Crude Oil

This too seems to have been a factor in the recent moves and there is some logic to this as of course the vast majority of oil business is settled in US Dollars. Not all of it anymore but a large proportion. Thus the rise in the price exemplified by the fact that the price of a barrel of Brent Crude Oil is now just below US $80 or some 52% over the past year has also sucked US Dollars out of the system. This is my view is of course mostly a timing thing as the oil producers will then spend them as for example one of the ways the money gets recycled is by the Gulf States buying weapons but we know that timing matters in the credit crunch era. Supposedly because we are more resilient as I look up that particular page in my financial lexicon for these times.

There are many views on this but here is one from a social media exchange I was involved in.

My thesis is the $/oil correlation is a consequence of oil market design/paradigm shift. This began 1st July 2017 & completed a couple of months ago. ie the dollar is now on an If I’m right, when (not if) oil falls the $ will fall with it ( @cjenscook )

Comment

Let us now look at it the other way from the point of view of the central bankers. Let me take you to the US Federal Reserve website where with something of a fanfare it declared this back in the day.

In May 2010, the FOMC announced that in response to the re-emergence of strains in short-term U.S. dollar funding markets it had authorized dollar liquidity swap lines with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank.

They had been gone for all of three months and were supposed to go as my emphasis below returns us again to my financial lexicon for these times.

 In October 2013, the Federal Reserve and these central banks announced that their existing temporary liquidity swap arrangements–including the dollar liquidity swap lines–would be converted to standing arrangements that will remain in place until further notice.

Very little is being used right now as one European bank has taken 80 million US Dollars worth in revolving 6 day credit or there are more than one. But this reminds me of the old wartime analogy of President FD. Roosevelt and loaning your neighbour a hose in case he has a fire. Meanwhile the emerging markets have started to be called the submerging ones.

The Libor problem is also a US Dollar problem

There is much to consider today as we consider the actions of our lords (ladies) and masters or rather our central bankers. Last night brought something which as we have noted before was in the category of “no surprises” sung about by Radiohead.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/2 to 1-3/4 percent. The stance of monetary policy remains accommodative,

That was of course the US Federal Reserve and I added the last bit because in a few words it tells us that they are not finished yet. Regular readers will be aware that I think it would be much better to simply raise rates to 2% and take a break as moving at at snail’s pace gives more time for something to go wrong. This brings me to two consequences of what is happening.

Libor

No not the scandals at least not yet! this time we are looking for the first time in a while at sustained increases. From Bloomberg yesterday.

The three-month London interbank funding rate rose to 2.27 percent Wednesday, the highest since 2008. The concern is that the Libor blowout may have more room to run, a prospect that borrowers and policy makers in various markets are just beginning to grapple with.

One way of looking at this is that as we expect more rises that seems reasonable and if we look at the past rather small fry.

Of course not all of us can remember 1994 and the financial world is of course to coin a phrase “resilient” at least according to the central bankers. This has led people to mull this.

“There has been sort of the perfect storm of factors tightening financial conditions,” said Russ Certo, head of rates at Brean Capital in New York. “Banks do have tremendous liquidity still, but it’s at a higher price.”

You may recall a few years back when worries about bank liquidity in US Dollars were all the rage. This was the era of central banks making agreements for foreign exchange swaps which were mostly ways of making sure they could get US Dollars for their banks from the original source ( the place that can print them at will….) if needed. Here is a refresher on the subject.

In November 2011, the Federal Reserve announced that it had authorized temporary foreign-currency liquidity swap lines with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. These arrangements were established to provide the Federal Reserve with the capacity to offer liquidity to U.S. institutions in currencies of the counterparty central banks (that is, in Canadian dollars, sterling, yen, euros, and Swiss francs). The Federal Reserve lines constitute a part of a network of bilateral swap lines among the six central banks, which allow for the provision of liquidity in each jurisdiction in any of the six currencies should central banks judge that market conditions warrant.

These exist for the opposite purpose as whilst the US Fed is describing things from its point of view and it may one day need some £’s Yen or Euros it is vastly more likely that the counterparty central bank will want US Dollars. After all if the world has a reserve currency in spite of some changes it is it and the likely song is from Aloe Blacc.

I need a dollar, dollar
Dollar that’s what I need
Well I need a dollar, dollar
Dollar that’s what I need
Said I said I need dollar, dollar
Dollar that’s what I need
And if I share with you my story would you share your dollar with me?

Oh and you may like to know that the US Federal Reserve eventually fell into line with the definition of temporary to be found in my financial lexicon for these times.

 In October 2013, the Federal Reserve and these central banks announced that their liquidity swap arrangements would be converted to standing arrangements that will remain in place until further notice.

The banks

In the end it all comes down to the “precious” of course and food for thought has been provided by what might be called the central bankers central bank choosing this morning to put this out on social media. From the Bank for International Settlements.

Non-US banks collectively hold $12.6 trillion of dollar-denominated assets – almost as much as US banks…….Dollar funding stress of non-US banks was at the center of the GFC. ( GFC= Global Financial Crisis).

They seem to be pointing the finger in one direction.

We find that Japanese banks pay a premium in their repurchase agreements (“repos”) with US MMFs. We show that the bargaining power of MMFs fund families, together with the particular demand for long term funding of Japanese banks, help explain this premium. ( MMF = Money Market Funds).

This has been a theme of my career which is that in terms of overseas buying ( UK Gilts, Australian property etc…) the Japanese overpay. Care is needed though as the stereotypical response of assuming stupidity ignores the possibility of a longer game being in play. In this instance they have responded.

 We provide evidence for European banks intermediating repos to Japanese banks, with economically significant estimated spreads from maturity transformation.

So any issues with the Japanese banks would also affect European ones? The mind boggles as of course contagion was supposed to be off the menu these days due to all the regulation and reform. As we look back I am reminded that it was European and on a smaller scale Japanese banks which dipped into these lines back in the day.

Would it be considered rude to point out that shares in my old employer Deutsche Bank are down another 2% as I type this? More significantly the 11.8 Euros is a fair bit lower than the 17.1 of mid-December.

Libor-OIS

As a consequence of the factors above this is also taking place. From Bloomberg reporting on some analysis from Citibank.

Strategists at the U.S. lender predict that the gap between the London interbank offered rate for dollars and the overnight indexed swap rate will continue to widen, potentially leading to a sharper tightening of financial conditions than central bankers have been anticipating. The differential between three-month rates has already more than doubled since the end of January to 55 basis points, a level unseen since 2009.

Now 55 basis points sounds much more grand that 0.55% but there is a flicker here as we try to price risk.

Comment

As you can see there are stresses in the financial system right now. Some of this was always going to take place when interest-rates went back up. But for me the real issue comes when we look at another market. This is because whichever way you look at the analysis here you would think that the US Dollar would be rising. You can arrive at that route by observing the apparent demand for US Dollars or by the higher interest-rates being paid in it or both. Yet it has been singing along to Alicia Keys.

Oh baby
I, I, I, I’m fallin’
I, I, I, I’m fallin’
Fall

I keep on
Fallin’

You can represent this by the UK Pound £ being in the US $1.41s or the Japanese Yen being in the 105s take your pick. The latter is off though because if Japanese banks are so keen for US Dollars why is the Yen so strong? To my mind that is much more worrying than Libor on its own as we switch to Carly Simon.

Why?……Don´t know why

Meanwhile returning to the shores of the UK I expect Royal Bank of Scotland to be along. After all it has been in everything else.