Is a reversal of the carry trade behind the rise of the US Dollar?

This morning brings us back to what has been a regular topic in 2018 which has been the US Dollar. Let’s look at it from the perspective of the sub-continent.

The rupee weakened further and dipped by 54 paise to 73.04 against the US dollar Monday, owing to increased demand for the American currency from importers amid increasing global crude oil prices.

International benchmark Brent crude was trading higher by 2.04 per cent at USD 71.61 per barrel.

Forex traders said besides increased demand for the US currency from importers, the dollar’s strength against some currencies overseas weighed on the domestic unit.

From India’s point of view this is not as bad as it has been as twice the Rupee has fallen through 74 versus the US Dollar. However the overall trend has been down as we recall promises it would not go through 70 and the fact it is 11% or so lower than a year ago. The recent dip – until this weekend’s OPEC meeting – did not benefit the Rupee much in comparison.

For Pakistan things have been even worse as it own troubles have led it back into the arms of the International Monetary Fund ( IMF). The Pakistan Rupee is at 134.3 versus the US Dollar or 28% lower than a year ago.

The Euro

This morning the Euro has dipped to 1.125 and Bloomberg is on the case.

The euro fell to its weakest in more than 16 months on Monday as traders fret political risks from Italy to Brexit.

Actually Bloomberg mostly ignores the Euro and concentrates on Brexit which of course is an influence but far from the only one. The weaker phase for the Euro area economy where quarterly economic growth has fallen from 0.7% to 0.2% does not merit a mention. Nor does the expansionary monetary policy of the ECB with its negative interest-rate and ongoing QE which still has a couple of months to run in monthly flow terms. On the other side of the coin is the ongoing trade surplus which supports the Euro but not so much today.

President Macron of France made a suggestion on this front on CNN over the weekend.From Politico.

Macron also talked in the interview about the need to strength the euro’s position as a global reference currency — not as a challenge to the U.S. dollar but as an alternative for purposes of stability.

I guess it and the Chinese Yuan will have to compete but I am not sure how several reference currencies would work? The Euro is of course very widely traded but still a long way behind the US Dollar.

Returning to economic policy this will give both Euro area inflation and the economy a boost. With inflation already around its target the ECB will not welcome the former but will the latter as economic growth has faded. Should it be out of play for a while in terms of monetary policy then the Euro area would have to deal with any further slow down with fiscal policy. That would be awkward after spending so much time telling Italy that it does not work.

The Dollar Index

If we broaden our view and look at an index of which President Macron would approve ( because of the high Euro weighting) we see that the Dollar Index has hit a 2018 high of just above 97.5 this morning. Whilst that is not up an enormous amount on a year ago ( less than 3%) there has been quite a push since it fell below 89 at the opening of the year.

The move has technical analysts in a spin as some see this as the start of a big move higher and others see this as an inflexion point. This proves that it is not only economists who can tell you that a market may go up or down!

US Monetary Policy

Economics 101 will be pleased that at least some of it can be brought out into the sun as the so-called normalisation of US monetary policy leads to a higher dollar. We seem set for another interest-rate increase next month as well as 2/3 more in 2019 meaning US interest-rates look set for the 3 handle.

Also there is a quantity issue as US Dollars are being withdrawn via the advent of Quantitative Tightening or QT. That is happening at the rate of 50 billion dollars a month which is a large sum in spite of the fact that these times have made us somewhat numb about such matters.

Comment

The media seem keen to find reasons for this burst of US Dollar strength which have nothing to do with the US itself. Personally I think the US holiday may be a factor in today’s move but as well as the change in monetary policy stance something else has been at play in 2018. This is the apparent shortage of US Dollars which back on the 18th of May was affecting relative interest-rates.

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. ( Bank Pictet).

That improved but has returned to some extent ( 30 earlier this month) and of course in the meantime US interest-rates are higher. On September 25th we looked at the way a new carry trade had developed but apparently stopped.

 The overall amount of dollar credit to the non-bank sector outside the United States has climbed from 9.5% of global GDP at end-2007 to 14% in the first quarter of 2018. Since end-2016, however, the growth in dollar credit has been flat.

What if that reverses? We know from what happened with the Swiss Franc and Japanese Yen that reversals of international carry trades can have powerful effects. At this time of year there is also usually demand for US Dollars for the end of the year. Although frankly if you are thinking of it now you are likely to be too late. For now at least it is time for Aloe Blacc.

I need a dollar dollar, a dollar is what I need
Hey hey
Well I need a dollar dollar, a dollar is what I need
Hey hey

As the US observes Veterans Day let me give a plug to They Shall Not Grow Old which was on BBC 2 last night and was quite something.

 

 

 

 

 

 

Advertisements

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

 

QE and its role in the Dollar shortage, zombie banks and productivity woes

Overnight there have been some intriguing releases from the BIS or Bank for International Settlements, which if you were not aware is the central bankers central bank. The BIS has, although it would not put it like that been reviewing some of the problems and indeed side-effects of the QE ( Quantitative Easing) era, So what does it tell us? Well one major point links to yesterday’s post on India and indeed to the travails of Argentina and Turkey.

The second defining feature is the rise of foreign currency US dollar credit . US dollar-denominated debt securities issued by non-US residents have been the key driver of this trend, surpassing bank loans for the first time in the second half of 2017 . The overall amount of dollar credit to the non-bank sector outside the United States has climbed from 9.5% of global GDP at end-2007 to 14% in the first quarter of 2018. Since end-2016, however, the growth in dollar credit has been flat.

So the US Dollar has been used as a new form of carry trade as people and businesses choose to borrow in it on a grand scale. Also as global GDP has been growing the 14% is of a larger amount. But to me the big connection here is the way that this pretty much coincides with plenty of US Dollars being available because the US Federal Reserve was busy supplying them in return for its QE bond purchases. Correlation does not prove causation but the surge fits pretty well and then it ends not long after QE did. Or more precisely seems to have faded after the first interest-rate increase from the Fed.

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. But it is hard to avoid noting the places that seem to be as David Bowie and Queen would put it.

It’s the terror of knowing what this world is about
Watching some good friends screaming, ‘Let me out’
Pray tomorrow gets me higher
Pressure on people, people on streets

Things seem set to tighten a little further tomorrow should the Fed tighten again as looks likely.

Zombie Companies and Banks

This development has been brought to you be the financial world equivalent of Hammer House of Horror. All the monetary easing has allowed companies to survive that would otherwise have folded, or to put it another way the road to what is called “creative destruction” or one of the benefits of capitalism was blocked. A major form of this was the way that banks were bailed out and some of them continue to struggle a decade later but also took us down other roads. For example the debt model of the Glazers at Manchester United looked set to collapse but was then able to refinance more cheaply in the new upside down world. Ironically it was then able to thrive at least financially as in football terms things are not what they were.

The BIS has its worries in this area too.

In this special feature, we explore the rise of zombie companies and its causes and consequences. We take an international perspective that covers 14 countries and a much longer period than previous studies.

It is willing to consider that the era of lower interest-rates and bond yields which covers my whole career and some has had consequences.

A related but less explored factor is the drop in interest rates since the 1980s. The ratcheting-down in the level of interest rates after each cycle has potentially reduced the financial pressure on zombies to restructure or exit. Our results indeed suggest that lower rates tend to push up zombie shares, even after accounting for the impact of other factors.

So cutting interest-rates for an economic gain looks to have negative consequences as time passes. How might that work in practice? The emphasis below is mine

Mechanically, lower rates should reduce our measure of zombie firms as they improve ICRs by reducing interest expenses, all else equal. However, low rates can also reduce the pressure on creditors to clean up their balance sheets and encourage them to “evergreen” loans to zombies . They do so by reducing the opportunity cost of cleaning up (the return on alternative assets), cutting the funding cost of bad loans, and increasing the expected recovery rate on those loans. More generally, lower rates may create incentives for risk-taking through the risk- taking channel of monetary policy. Since zombie companies are risky debtors and investments, more risk appetite should reduce financial pressure on them.

The reason for the emphasis is that in essence that is the rationale for QE. That is something of a change on the past but as inflation as measured by consumer inflation mostly did not turn up the central banks got out their erasers and deleted that bit. It has been replaced by this sort of thing which links to the Zombie companies and banks theme.

In addition, QE can stimulate the economy by boosting a wide range of financial asset prices. ( Bank of England )

Note the use of the word can so that even the Take Two version can be erased! But the crucial point is that yet again the Zombies are on the march via central banking support. I guess most of you have already guessed the next bit.

Visual inspection suggests that the share of zombie firms is indeed negatively correlated with both bank health and interest rates.

Why are Zombies such a problem?

The have negative effects on economic life.

a higher share of zombie firms could depress productivity growth,

Could? Later we get more of a would as we see an old friend called “crowding out” return to the picture.

Zombies are less productive and may crowd out growth of more productive firms by locking resources (so-called “congestion effects”). Specifically, they depress the prices of those firms’ products, and raise their wages and their funding costs, by competing for resources.

But there is a deeper consequence.

We find that when the zombie share increases, productivity growth declines significantly, but only for the narrowly defined zombies………. The estimates indicate that when the zombie share in an economy increases by 1%, productivity growth declines by around 0.3 percentage points.

Comment

There is a fair bit to consider here. The first is the role of the BIS in this which in some ways is welcome but in others less so.  The former is an admittal of some of the side-effects of easy monetary policy but the latter is the way we are getting it a decade late. Or in the case of Japan a couple of decades or so late! To my mind intelligence also involves an element of timeliness. Although to be fair to do quantitative research you do need an evidence base. The catch as ever for the evidence in economics is the way that some many things are varying not only with each other but also with themselves over time. Or if you prefer heteroskedasticity and multicollinearity.

As to the issues they tend to be on the back burner because they are inconvenient for the establishment. The career path of economists at central banks is unlikely to be improved by research into the collateral damage of its policies especially ones which it may not be able to reverse. At the moment both ZIRP and QE are in that category even in the US. So should the period of QT lead to the issue below rising in volume get ready for the claims that it could not have been expected and is nobody’s fault.

I need a dollar dollar, a dollar is what I need
Hey hey
Well I need a dollar dollar, a dollar is what I need
Hey hey

On that subject I note that a bank borrowed 563 million Euros from the ECB overnight which is odd with so much Euro liquidity around. Next we come to the issue of the productivity puzzle which seems likely to have a few of its pieces with zombie companies on it. The same zombie companies and especially banks that have been so enthusiastically propped up. Time for some Cranberries.

Zombie, zombie, zombie, ei, ei
What’s in your head?
In your head
Zombie, zombie, zombie

The economic impact of the King Dollar in the summer of 2018

One of the problems of currency analysis is the way that when you are in the melee it is hard to tell the short-term fluctuation from the longer-term trend. It gets worse should you run into a crisis as Argentina found earlier this year as it raised interest-rates to 40% and still found itself calling for help from the International Monetary Fund. The reality was that it found itself caught out by a change in trend as the US Dollar stopped falling and began to rally. If we switch to the DXY index we see that the 88.6 of the middle of February has been replaced by 95.38 as I type this. At first it mostly trod water but since the middle of April it has been on the up.

Why?

If we ask the same question as Carly Simon did some years back then a partial answer comes from this from the testimony of Federal Reserve Chair Jerome Powell yesterday.

Over the first half of 2018 the FOMC has continued to gradually reduce monetary policy accommodation. In other words, we have continued to dial back the extra boost that was needed to help the economy recover from the financial crisis and recession. Specifically, we raised the target range for the federal funds rate by 1/4 percentage point at both our March and June meetings, bringing the target to its current range of 1-3/4 to 2 percent.

So the heat is on and looks set to be turned up a notch or two further.

 the FOMC believes that–for now–the best way forward is to keep gradually raising the federal funds rate.

One nuance of this is the way that it has impacted at the shorter end of the US yield curve. For example the two-year Treasury Bond yield has more than doubled since early last September and is now 2.61%. This means two things. Firstly if we stay in the US it is approaching the ten-year Treasury Note yield which is 2.89%. If you read about a flat yield curve that is what is meant although not yet literally as the word relatively is invariably omitted. Also that there is now a very wide gap at this maturity with other nations with Japan at -0.13% and Germany at -0.64% for example.

At this point you may be wondering why two-year yields matter so much? I think that the financial media is still reflecting a consequence of the policies of the ECB which pushed things in that direction as the impact of the Securities Markets Programme for example and negative interest-rates.

QT

QT or quantitative tightening is also likely to be a factor in the renewed Dollar strength but it represents something unusual. What I mean by that is we lack any sort of benchmark here for a quantity rather than a price change. Also attempts in the past were invariably implicit rather than explicit as interest-rates were raised to get banks to lend less to reduce the supply of Dollars or more realistically reduce the rate of growth of the supply. Now we have an explicit reduction and it has shifted to narrow ( the central banks balance sheet) money from broad money.

 In addition, last October we started gradually reducing the Federal Reserve’s holdings of Treasury and mortgage-backed securities. That process has been running smoothly.  ( Jerome Powell).

You can’t always get what you want

It may also be true that you can’t get what you need either which brings us to my article from March the 22nd on the apparent shortage of US Dollars. This is an awkward one as of course market liquidity in the US Dollar is very high but it is not stretching things to say that it is not enough for this.

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). ( BIS)

The issue faded for a bit but seems to be on the rise again as the Libor-OIS spread dipped but more recently has risen to 0.52 according to Morgan Stanley. What measure you use is a moving target especially as the Federal Reserve shifts the way it operates in interest-rate markets but they kept these for a reason.

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.

Impact on the US economy

The situation here was explained by Federal Reserve Vice-Chair Stanley Fischer back in November 2015.

To gauge the quantitative effects on exports, the thick blue line in figure 2 shows the response of U.S. real exports to a 10 percent dollar appreciation that is derived from a large econometric model of U.S. trade maintained by the Federal Reserve Board staff. Real exports fall about 3 percent after a year and more than 7 percent after three years.

Imports are affected but by less.

The low exchange rate pass-through helps account for the more modest estimated response of U.S. real imports to a 10 percent exchange rate appreciation shown by the thin red line in figure 2, which indicates that real imports rise only about 3-3/4 percent after three years.

And via both routes GDP

The staff’s model indicates that the direct effects on GDP through net exports are large, with GDP falling over 1-1/2 percent below baseline after three years.

The impact is slow to arrive meaning we are likely to be seeing the impact of a currency fall when it is rising and vice versa raising the danger of tripping over our own feet in analysis terms.

What happens to everyone else?

As the US Dollar remains the reserve currency if it rises everyone else will fall and so they will experience inflation in the price of commodities and oil. This is likely to have a recessionary effect via for example the impact on real wages especially as nominal wage growth seems to be even more sticky than it used to be.

Comment

Responses to the situation above will vary for example the Bank of Japan will no doubt be saying the equivalent of “Party on” as it will welcome the weakening of the Yen to around 113 to the US Dollar. The ECB is probably neutral as a weakening for the Euro offsets some of its past rise as it celebrates actually hitting its 2% inflation target which will send it off for its summer break in good spirits. The unreliable boyfriend at the Bank of England is however rather typically likely to be unsure. Whilst all Governors seem to morph into lower Pound mode of course it also means that people do not believe his interest-rate hints and promises. Meanwhile many emerging economies have been hit hard such as Argentina and Turkey.

In terms of headlines the UK Pound £ is generating some as it gyrates around US $1.30 which it dipped below earlier. In some ways it is remarkably stable as we observe all the political shenanigans. I think a human emotion is at play and foreign exchange markets have got bored with it all.

Another factor here is that events can happen before the reasons for them. What I mean by that was that the main US Dollar rise was in late 2014 which anticipated I think a shift in US monetary policy that of course was yet to come. As adjustments to that view have developed we have seen all sorts of phases and we need to remember it was only on January 25th we were noting this.

The recent peak was at just over 103 as 2016 ended so we have seen a fall of a bit under 14%

Back then the status quo was

Down down deeper and down

Whereas the summer song so far 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

Me on Core Finance

 

 

 

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.

What are the consequences of a weak US Dollar?

So far 2018 has seen an acceleration of a trend we saw last year which is a fall in the value of the US Dollar. The latest push was provided by the US Treasury Secretary only yesterday at Davos. From Bloomberg.

“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.

“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.

The way it then fell it is probably for best its value is not a concern as the rhetoric was both plain and transparent.

A day before Trump’s scheduled arrival in the Swiss ski resort of Davos for the World Economic Forum’s annual meeting, Treasury Secretary Steven Mnuchin endorsed the dollar’s decline as a benefit to the American economy and Commerce Secretary Wilbur Ross said the U.S. would fight harder to protect its exporters.

The response to the words is a pretty eloquent explanation of why policy makers have a general rule that you do not comment on the level of the exchange rate. Not only might you get something you do not want there is also the issue of being careful what you wish for! Sadly the Rolling Stones were not on the case here.

You can’t always get what you want
But if you try sometime
You’ll find
You get what you need

However you spin it we are in a phase where the US government is encouraging a weaker dollar as part of the America First strategy. It has already produced an echo of the autumn of 2010 if this from the Managing Director of the IMF is any guide.

 “It’s not time to have any kind of currency war,” Lagarde said in an interview with Bloomberg Television.

Criticising someone for rhetoric by upping the rhetoric may not be too bright. Also there are more than a few examples of countries trying to win the race to the bottom around the world.

What does a lower US Dollar do?

Back in November 2015 Stanley Fischer gave us the thoughts of the US Federal Reserve.

To gauge the quantitative effects on exports, the thick blue line in figure 2 shows the response of U.S. real exports to a 10 percent dollar appreciation that is derived from a large econometric model of U.S. trade maintained by the Federal Reserve Board staff. Real exports fall about 3 percent after a year and more than 7 percent after three years.The gradual response of exports reflects that it takes some time for households and firms in foreign countries to substitute away from the now more expensive U.S.-made goods.

Also imports are affected.

The low exchange rate pass-through helps account for the more modest estimated response of U.S. real imports to a 10 percent exchange rate appreciation shown by the thin red line in figure 2, which indicates that real imports rise only about 3-3/4 percent after three years.

This means that the overall economy is affected as shown below.

The staff’s model indicates that the direct effects on GDP through net exports are large, with GDP falling over 1-1/2 percent below baseline after three years. Moreover, the effects materialize quite gradually, with over half of the adverse effects on GDP occurring at a horizon of more than a year.

Okay we need to flip all of that around of course because we are discussing a lower US Dollar this time around. Net exports will be boosted which will raise economic output or GDP over time.

How much?

If we look at the US Dollar Index we see at 89.1 it has already fallen by more than 3% this year. The recent peak was at just over 103 as 2016 ended so we have seen a fall of a bit under 14%. The official US Federal Reserve effective exchange rate has fallen from 128.9 in late December 2016 to 116.8 at the beginning of this week so 116 now say. Conveniently that gives us a fall of the order of 10%.

So if we look up to the preceding analysis we see that via higher exports and reduced imports US GDP will be 1.5% higher in three years time than otherwise.

What about inflation?

There is a lower impact on the US because of the role of the dollar as the reserve currency and in particular as the currency used for pricing the majority of commodities.

While the Board staff uses a range of models to gauge the effect of shocks, the model employed in figure 4–as well as other models used by staff–suggests that the dollar’s large appreciation will probably depress core PCE inflation between 1/4 and 1/2 percentage point this year through this import price channel.

You may note that Stanley Fischer continues the central banking obsession with core inflation measures when major effects will come from food and energy. It would be entertaining when they sit down to luncheon to say that we are having a core day so there isn’t any! Have you ever tried eating an i-pad?

So inflation may be around 0.5% higher.

What about everybody else?

The essential problem with reducing the value of your currency to boost your economy via exports is that overall it is a zero-sum game. As you win somebody else loses.  So the gains are taken from somebody else as no doubt minds in Beijing, Tokyo and Frankfurt are thinking right now. Of course pinning an actual accusation on the United States is not easy because of its persistent trade deficits.

Furthermore the exchange-rate appreciation seen elsewhere will not be welcomed by the ECB ( European Central Bank) and particularly the Bank of Japan. The latter is pursuing an explicit Yen depreciation policy to try to generate some inflation whereas what it has instead seen is a rise towards 109 versus the US Dollar. Of course workers and consumers will have reason to thank the lower dollar as lower inflation will boost their spending power.

Later today we will see how Mario Draghi handles this at the ECB policy meeting press conference. He finds himself pursuing negative interest-rates and still substantial if tapering QE and a stronger currency. It is hard for him to be too critical of the US though when even Christine Lagarde is saying this.

LAGARDE: GERMANY’S 8% CURRENT ACCOUNT SURPLUS IS EXCESSIVE ( @lemasabacthani)

Of course that takes us back to a past competitive depreciation which Germany arranged via its membership of the Euro.

Comment

There is a fair bit to consider here. As it stands it looks as though the US economy will benefit over the next 3 years (convenient for the political timetable) by around 1.5% of GDP at the cost of higher inflation of 0.5%. There are two main problems with this type of analysis of which the first is simply the gap between theory and reality. The smooth mathematical curves of econometrics are replaced in practice by businesses and consumers ignoring moves for as long as they can and then responding but by how much and when? So we see a succession of jump moves. The other issue is that exchange-rates are usually on the move and can change in an instant unlike economies leaving us wondering which exchange-rate they are responding too?

Next we have the awkward issue of a country raising interest-rates and seeing a currency depreciation. Theory predicts the reverse. I have a couple of thoughts on this and the first is about timing. In my opinion exchange-rates these days move on expectations of an event so they have already happened before it does. So the current phase of interest-rate rises was reflected in the US Dollar rise from the summer of 2014 to the spring of 2015. That works because if anything we have seen fewer rate rises than expected back then and the bond market has fallen less. As to the Federal Reserve well with the US Dollar here and inflation with a little upwards pressure it will therefore find a scenario which makes it easy for it to keep nudging interest-rates higher.

Meanwhile there are other factors which are hard to quantify but seem to happen. For example a lower dollar coming with higher commodity prices. Hard to explain and of course there are other factors in play, But it seems to have happened again.

Me on Core Finance TV

http://www.corelondon.tv/will-pound-go-next-vs-us-dollar/