I’ve said it before and I’ll say it again: I do not mind beating a dead horse. That’s especially true when I think investors might be underestimating the importance of some trend, theme, or market dynamic.
I’ve penned probably a dozen pieces on the worsening global USD shortage over the past six or so months. The dollar dearth is showing up in deeply negative EUR and JPY cross currency basis markets. Typically, that would portend risk aversion. But not this time:
Part of the problem is the $800 billion or so of dollar liquidity that was sucked from the system by US money market reform, the effects of which are readily apparent in soaring 3-month LIBOR:
(Chart: Bloomberg/Morgan Stanley)
This has obvious implications for those with USD debt, but it also forces those hedging USD assets to rethink their strategy. Here’s how I put it on Tuesday:
Think about it. If the USD/JPY is headed higher anyway and the cross currency basis is blowing out, why in the world would you sacrifice 170bps in yield to hedge out your USD exposure?
Well, you wouldn’t. What you’d do if you were say, a Japanese insurance company, is reduce your hedging ratios (which are unusually high given recent JPY weakness).
The takeaway here is simply this: all signs point to more USD strength ahead. Here with some excellent (and succinct) commentary on everything discussed above is SocGen:
Lower oil prices and falling global FX reserves have reduced the availability of dollars in global money markets in 2016. Demand from those with dollar liabilities, especially those with debt to roll over, is strong. The mismatch is putting upward pressure on short term Eurodollar money market rates, and on the cross-currency basis market, as increased cost of balance sheet makes arbitraging that market more expensive. The 3-month EUR/USD cross-currency basis is at its most negative since the sovereign debt crisis back in 2012.
How much does this matter? Let’s put it into context — borrowing money over the turn of the year is relatively expensive but at 4.5%, it’s not unbearable — I remember intra-day rates that were vastly higher in the late 1980s. Furthermore, there really isn’t a very compelling correlation between short-term spikes in the cost of borrowing dollars, and the currency’s value. There is a correlation between a falling EUR/USD rate and a falling basis, but even that doesn’t tell me a whole lot about causality. And yet, if the strains reflect stronger demand for and decreased supply of dollars in markets, intuitively, it’s bound to be dollar-supportive to some degree. Foreign holders of US assets have to pay more to hedge the FX risk, for example, which means they either sell their US bonds (say) driving yields up, or they reduce their hedging ratios (driving the dollar up).
Trade (and hedge) accordingly.