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.
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 U.S.Federal Reserve 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.
That could have also been down to quarter-end rebalancing by banks or worries over Italy prompting a surge in hedged outflows from the euro zone. Still, it’s a remarkable move, and when you add in other measures the cost of borrowing dollars for overseas investors, companies and financial institutions is higher now than any point since 2009.
And the direction of travel is only going one way: higher.
This is flashing amber, if not red, for dollar borrowers around the world exposed to a rising U.S. currency, yields and interest rates, all of which increase their liabilities and make it harder to service and repay the debt.
On top of that, U.S. money market reforms and stricter banking regulations have curtailed U.S. banks’ capacity for dollar liquidity provision.
U.S. President Donald Trump’s tax reforms have diverted some of the huge U.S. corporate cash pile abroad back home, and have also made it more expensive for U.S. branches of overseas banks to raise onshore funds.
Meanwhile, the risk of a sudden spike in risk aversion that would trigger capital outflows from emerging markets, like a full-blown global trade war, is ever present and rising. As we saw this summer, capital flight doubles the pain for emerging market (EM) borrowers and exacerbates the dollar liquidity squeeze more broadly.
“The cost of borrowing dollars, especially offshore dollars, will continue to rise, putting considerable pressure on global financing conditions,” says Shweta Singh at TS Lombard. “The main threat to global financing is an offshore dollar squeeze.”
Dollar dominance ... and reliance
Three-month dollar funding costs are currently running around 2.50 per cent. 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.
The Fed’s QE (quantitative easing) is well and truly over, and QT (quantitative tightening) is in full flow. The Fed’s balance sheet reduction alone will soon be sucking as much as US$50-billion a month, or US$600-billion a year, out of the system.
Then there’s the sharp rise in Treasury supply to fund Trump’s US$1-trillion of tax cuts and defense spending. Gross issuance topped US$1-trillion on a monthly basis for the first time ever in August, according to SIFMA data.
That sucking sound gets louder as banks, funds and other financial institutions buy these bonds, and in doing so part with cash that would otherwise flow through the system elsewhere.
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 per cent of global GDP at the end of March this year, up from 9.5 per cent 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 US$3.7-trillion since the crisis and a similar amount has been borrowed through currency swaps.
“The high share of dollar borrowing foreshadows risks that could materialize in the case of a persistent dollar appreciation,” the BIS said in its Quarterly Review earlier this week.
“A stronger dollar increases tail risks for global investors holding a diversified portfolio of emerging market assets, which can lead to widespread reductions in emerging market exposures.”
Non-U.S. banks who have borrowed trillions of dollars are potentially exposed to a currency mismatch between their assets and liabilities. Most don’t have access to stable dollar deposits, nor can they easily access dollar deposits at their U.S. subsidiaries.
They are forced to rely heavily on less stable and increasingly expensive, short-term sources of dollar funding. A squeeze could hurt.
Reuters