USD rally flashing a warning signal to global markets
- US dollar shortage in global markets has become acute
- Excess profits available for those with access to USD
- Demand for hedging is the driver of excess demand for dollars
By Max McKegg
This looks like being a quiet week in the markets leading up to Friday’s US jobs report, so it’s an opportunity to step back and look at the bigger picture.
In particular: What is the rally in the US dollar telling us, and what are the implications if it continues?
Does it matter that access to US dollars is becoming an acute problem in global FX and money markets? Should the US Federal Reserve step in and become an international lender of last resort?
The market tension shows up in the cross currency swap basis, now a mirror image of the USD trade weighted index. Let’s have a look at what’s going on.
As always, there are winners and losers when markets are unbalanced. First, the winners.
US based financial institutions can use the cross currency swap market to generate substantially higher returns than those available at home.
Consider the chart below showing the 3 month USDJPY cross currency basis, which has blown out to 80 basis points.
In normal market conditions the basis should be close to zero, in line with covered interest parity, the closet thing you get to a universal law in finance.
It states that the cost (or benefit) of hedging foreign currency exposure will equal the interest rate differential, no more, no less.
But, in extreme cases – such as now - where there is excess demand on one side of the trade, the cost (or benefit) of hedging can exceed the rate differential. This additional amount is called the “basis”.
For example, three month Treasury bills in Japan yield -0.20% while the US equivalent pays +0.50%. On the face of it, no US-based investor would choose the Japanese option.
But the three month USDJPY basis is at 80 basis points. That’s the extra return above the interest rate differential the US investor would earn by purchasing the Japanese notes and hedging the JPY exposure back to USD.
At the moment, three month USD Libor rate is 95 basis points above the Japanese equivalent. So an investor with access to USD can buy a three month Japanese note at a yield of -0.20% and hedge the currency exposure via the cross currency swap market, picking up the usual rate differential (95 basis points) plus the basis (80 basis points), a total of 1.75% annual.
Deduct the negative yield on the note and the net return on a gilt edged security is about 1.50%, triple that offered by the US equivalent.
Of course, these “free lunches” wouldn’t exist in a world where covered interest parity applied, being quickly closed down by arbitrageurs.
And for decades banks did just that, earning big profits for their efforts. But with the advent of the Basel III reforms (and Basel IV just around the corner) banks now face restrictions on leverage and derivative exposure.
The rising cost of balance sheet “space” means that many arbitrage opportunities are going begging.
While those with access to US dollar funds are benefiting from this situation, the other side of the coin is an increase in costs for those who need to borrow dollars through the cross currency swap market for hedging purposes.
In the case of Japan, banks have excess JPY deposits on their books because domestic loan demand is weak. Always keen to expand their overseas business, the banks lend JPY in the cross currency swap market and borrow dollars.
They then lend these dollars out through their US-based branches. At the same time Japanese institutional investors are buying US bonds to avoid the zero-bound rate structure in their home market.
To fund the purchases, they buy USD and sell JPY in the spot market and then reverse (hedge) that trade via the swap market, effectively selling (borrowing) USD and buying (lending) JPY.
So both the banks and institutional investors are coming from the same side, pushing up the cost of borrowing USD via swaps.
This was best illustrated pre-Trump when USD Libor went through 80 basis points, USDJPY basis was approaching a similar number and the yield on 10-year US Treasury bonds was 1.6%.
Therefore the total cost of hedging equalled the yield on the bonds, making the exercise pointless (see chart below).
Not surprisingly Japanese demand dried up, but is now picking up again in line with the sharp rise in US yields seen over the last couple of weeks.
It’s not only the USDJPY basis that has dropped. A similar situation, although not as acute, applies in the Eurozone where the USDEUR basis is negative 0.40%.
A significant factor here is US-based corporations issuing bonds in EUR and swapping the proceeds back into borrowed dollars.
While the USD basis is negative for JPY and EUR, in places like Australia and New Zealand it’s positive because there’s a shortfall of domestic deposits relative to loan demand and banks are funding the gap by borrowing AUD and NZD and lending USD via swaps in sufficient amounts to offset local institutions investing offshore and putting on currency hedges.
The combined picture across the G10 is illustrated by this chart.
Source: Bank for International Settlements
Note that prior to the GFC, the basis was tracking along at zero, as per covered interest parity.
Since then it's been negative. More significantly, the sharp move from 2014 has coincided with a rally in the USD trade-weighted index.
If the cross currency swap basis has become a barometer of leverage and risk taking capacity in the global banking sector, then the US dollar is its mirror image.
In a recent paper (see here) the Head of Research at the Bank for International Settlements summarised the situation this way:
“The dollar as the barometer of leverage and risk-taking capacity has implications both for financial stability and the real economy. If banks put such a high price on balance sheet capacity when the financial environment is largely tranquil, what will happen when volatility picks up?
"If banks react to resurgent volatility by reducing their intermediation activity, as happened during the 2007–09 crisis, the banking sector may become an amplifier of shocks rather than an absorber of shocks.
"The deviation from covered interest parity provides a window on the shadow price of bank balance sheet capacity. For this reason, it would be important for policymakers to keep a close eye on this formerly rather esoteric corner of the foreign exchange market.”
What will happen then if USD continues to rally ? Here is the final sentence from the paper:
“The three great economic puzzles of our time – slow productivity growth, the slowdown in trade and the failure of covered interest parity – may all be related. Given the dollar's role as barometer of global appetite for leverage, there may be no winners from a stronger dollar.”
And what if the US Federal Reserve were to step in and increase US swap lines with other central banks? Would that solve the problem? That’s a question for another day.
-- Edited by Adam Courtenay
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.