Category Archives: FX

Dollar shortage vs. dollar funding stress

19 Thursday Mar 2020

Posted by in FX

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I think we should distinguish between dollar shortage and dollar funding stress. We have a lot of the latter and much less of the former compared to any previous crisis.

‘Dollar shortage’ is your classical EM currency crisis stemming from a balance sheet currency mismatch: borrow in dollars to fund a non-dollar asset. Cue Mexico’94, Asia’97, Russia’98, Brazil’99, Turkey’01, Argentina’01. There are fewer of them nowadays.

A ‘dollar funding stress’ stems from borrowing in dollars to fund a dollar asset – that’s the problem today (see for ex. Z. Pozsar’s latest). It feels like the old EM currency crises because a lot of dollar assets are owned by foreigners but it is very different at the same time as there are no balance sheet currency mismatches.

That distinction is important because the market is treating it as if it is a dollar shortage crisis while it is a classic ‘Mark-to-market (MTM)’ crisis. If the dollars were borrowed through the swap market, refinancing would widen the basis and move the currency. If the borrowing was in the loan/bond market, it would be a credit story, not a currency story.

There is also a break even price for dollar funding above which foreigners would choose to sell the dollar asset and repay the loan, rather than continue to finance it (probably they will have to top up if the MTM has moved too much from where they bought it). All this is a very different situation from a dollar shortage crisis whereby they would need to sell a local currency asset and actually convert proceeds into dollars.

The Fed is well aware of all this and has acted very swiftly to respond to the recent strengthening of the dollar by improving massively the terms of the five existing central bank swap lines and by adding today nine more to the frame. The extraordinary moves in some DM currencies, notably NOK and AUD, has also prompted the respective central banks to verbally intervene (Norges) or ‘not to rule out’ intervention (RBA).

Some people have mentioned to me that a new Plaza Accord is needed. I am not so sure. In my opinion, it would be counterproductive. From a behavioral point of view, a weak dollar is not necessarily beneficial for US assets given that a big chunk of them is owned by foreigners. Just like a worsening of the dollar funding terms may push these people to sell, so could an attempt to substantially weaken the dollar. We shouldn’t forget a small but very much overlooked fact of the 1987 stock market crash: on the weekend before Black Monday, the US Treasury Secretary threatened to devalue the dollar.

Bottom line is that a dollar funding crisis should have a much smaller effect on weakening the local currency than a dollar shortage crisis. The market does not need a dollar devaluation, rather a stable dollar. Policy makers should make sure foreign dollar funding does not blow up. And finally, market pundits should be careful exaggerating the dollar shortage issue.

Fed’s crisis response may endanger the dollar

13 Friday Mar 2020

Posted by in Equity, FX

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The response from the two most powerful central banks could not have been more different. ECB is innovative, using fine tuning and precision in tiered rates and targeted lending; Fed is still throwing the kitchen sink at the market by flooding the banking system with liquidity.

ECB is also going more direct partially because the banking system there is in shatters, but also because it makes sense regardless. Plus, the ECB is already taking credit risk by buying corporate bonds. Surely, the next step is literally direct credit lending and massively expanding the ECB counterparty list.

Fed is still stuck in the old model of credit transmission, entirely relying on the banking system. That model died in 2008, in fact, even before that, in the early 2000s, as the first Basel rules came into effect and the shadow banking system flourished.

Post 2008 it became much more common for financial institutions, like PE etc. to get in the credit loan business. Needless to say, this carries a big risk given that they don’t have access to Fed’s balance sheet like the banks.

The US banking system is now flooded with liquidity. If the new repo auctions are fully subscribed, this will double banks’ reserve balances and will bring them to the peak post the 2008 crisis. But do banks need that liquidity?  It does not seem so: the first $500Bn repo auction yesterday had just $78Bn of demand. But that liquidity from the Fed is there on demand, plus the central banks swaps lines are open, and as of March 12, none has been drawn. And finally, the foreign reverse repos pool balance at the Fed has not shown any unusual activity (no drawdowns). All this is indicating that USD liquidity is at the moment sufficient, if not superfluous, so, it should have a negative effect on USD, given long USD has been a popular position post 2008.

All this liquidity, however, may still do nothing to stocks, as seen by their performance into the close yesterday, because balance sheet constraints prevent banks from channelling that liquidity further into the US economy where it is surely needed. From one hand, the Fed is really pushing on a string when it comes to domestic dollar liquidity, but, on the other, it is providing more than plenty abroad. 

Risky assets are still a sell on any bounce, and the USD is probably a sell as well, as the Fed will be forced to keep cutting but it is now running a risk of foreign money exiting long established overweight positions in US assets.