Article / 18 August 2016 at 1:31 GMT

Money market imbalances should provide support for USD

Managing Director / Technical Research Limited
New Zealand
  • There is a shortage of US dollars in the money markets
  • This is reducing the attractiveness of the US bond market for offshore investors
  • The situation makes the bond market vulnerable if the Fed resumed raising rates
  • This shortage of US dollars means any decline in the USD should find support

By Max McKegg

The minutes from the US Federal Reserve Board’s July 26-27 meeting released yesterday had little impact on FX or money markets. It seems the Fed is tying itself in knots with plenty of "on the one hand but on the other" discussions, typical when a group of economists get together. The 17-member committee’s general view was probably best summed up by this quote from the minutes:
Given their economic outlook, they judged that another increase in the federal funds rate was or would soon be warranted, with a couple of them advocating an increase at this meeting.” 

Ready to hike? The market is pricing in the chance of a rate rise by the
end of the year at about 50-50. Photo: iStock

However, only 10 members get a vote on whether or when to raise rates and “the couple” who wanted to pull the trigger at the July meeting aren’t voters, so for them talk is cheap. As for what the word “soon” means (as in “an increase in the federal funds rate would soon be warranted”), we are none the wiser. 

No surprise then that market pricing suggests the chance of a rate hike by year end is about 50-50. The calculation is quite complicated, but the chart below of the December 2016 federal funds futures gives a reasonable guide (Click to enlarge). 

As of today the federal funds rate trades around 0.40% (a price of 99.60) close to the middle of the Fed’s 0.25-0.50% target band. So a 25 basis point increase to the target band would see fed funds trading around 0.65% (a price of 99.35) the bottom line on the chart. If the Fed has not raised the target by year-end then the December futures contract will close out at 0.40%, the top line on the chart. 

As you can see, today the futures price is trading in the middle of the range, suggesting a 50-50 chance of a rate hike.

December 2016 fed funds futures
Source: Metastock
As for the inflation outlook, the minutes said “a couple” of members preferred to wait for more evidence that it would rise to 2% “on a sustained basis” before raising rates. Yesterday’s July Consumer Price Index numbers would have given them further reason to sit on the fence. A slump in energy prices saw the year-on-year rate of increase drop back to 0.84%, while the core rate struggled to hold steady at 2.2%.

Meanwhile, the actual cost of borrowing US dollars is disconnecting from the top of the range of the Fed’s current rate target, as shown in the chart below. Three month Libor has hit 0.8% as rule changes come into effect that mean US money market funds are unable to lend as many dollars to European and other non-US banks. 

To cover the funding gap those banks are borrowing in other currencies, such as EUR or JPY, and hedging the currency risk in the cross currency foreign exchange market. 


Source: The Daily Shot
This has pushed the EURUSD and USDJPY basis out to the highest levels in five years, which is having a big impact on global bond markets.
Since the beginning of this year, after the Bank of Japan introduced negative rates and set in motion a big rally in the local bond market, Japanese investors have been diversifying into US Treasuries. 

To avoid being caught out by a decline in USDJPY, many have been hedging the exchange rate risk. But, as per the interest rate parity theorem, if a Japanese-based investor buys a 10-year US Treasury and puts in place a 10-year USDJPY hedge, the effective yield will be the same as that earned on a 10-year JGB. In other words, the cost of hedging will equal the interest-rate differential. No point in that then.
In practice, the hedging is done by rolling over shorter dated contracts in the cross currency foreign exchange market where the rate differential in narrower. But because so many are on the one side of the trade, the USDJPY cross currency basis swap has blown out. So when the Japanese investor swaps JPY for USD to buy a 10-year US Treasury bond at a yield of 1.55%, instead of earning interest on the JPY they lend out, they are effectively paying about 0.65%. 

Add that to the cost of borrowing dollars (3 month Libor at 0.80%) and the total cost of the hedge at 1.45% almost equals the 1.55% yield on the bond itself.
That’s a big change from the 1% pick-up available earlier in the year, as shown in this chart. A similar situation exists for EUR-based investors.


Source: Bloomberg

The upshot is that a shortage of US dollars is reducing the attractiveness of the US bond market for offshore investors, making it more vulnerable if the Fed was to resume raising rates. So far all we have heard from the Fed is talk, often from non-voting members who have less skin in the game, and the markets have got it right in pricing the odds of a move by the end of the year at 50%. 

But with a shortage of dollars in the money markets, any decline in the USD in the meantime should find keen support.

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
wang fei wang fei
how about EURUSD?
Max McKegg Max McKegg
today's trade view feautures NZDUSD ... am limited to contributions on TradingFloor ... will try to include EURUSD ahead OK
lahla lahla
Hello. Thanks for the great analysis, article. I really got lost when You explained the dynamics of hedging the positions. Firstly You avoid a DECLINE in USDJPY (the japanese investor who owns US BONDS). He actually sells or buys USDJPY to hedge the position? Secondly how do You derive that the investor who bought us bonds and hedge the position actually pays 0,65%. Is this the current swap ration? Finally this analysis explains the decline in the USDJPY that has occured the last months?
Max McKegg Max McKegg
If a Japan-based investor buys US Treasury bonds without hedging the currency risk he wants JPY to decline against the USD i.e. for USDJPY to rise. So, as per my Article, he wants to avoid the risk of a *decline* in USDJPY (i.e a rise in JPY). To eliminate that risk, and that currency movement out of the return calculation, he would need to hedge. His initial trade was to buy USDJPY (to produce dollars to pay for the Treasury bond) and at the same time he needs to sell USDJPY in the forward market. Normally the forward market would reflect interest rate differentials. But because so many people are coming from the same side there is an added cost, currently about 0.65%
lahla lahla
Thank You very much. You are incredible valuable to this community.


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