Via Nedbank’s Neels Heyneke & Mehul Daya
Since 2014 when the Fed’s balance stopped expanding and the oil price collapsed (petrodollars), the world has been plagued with a dollar shortage problem. As a result, excess reserves at the Fed stopped growing. The shortage of dollars is a longer-term structural problem for the world.
Some background information first: In the 2008/9 GFC, the Fed engaged in extraordinary measures such as quantitative easing to provide the financial system with liquidity. Simultaneously the Fed also began paying interest on excess reserves (IOER) to control this liquidity and the bank excess reserves at the Fed grew from $500bn to $2.3tn. The composition is also important to note as foreign banks account (mainly European banks) for 40% of the excess reserves held at the Fed.
Amid the dollar shortage, foreign banks began withdrawing dollars from the Fed for funding requirements in the Eurodollar system.
Since 2014, we have written many times that the quantum of money in the system is now equally, if not more important, than the price of money (policy rates).
Cyclical forces: The US treasury maintains a healthy cash balance at banks, but as the debt ceiling approaches it utilizes these cash balances to avoid reaching the looming debt limit. This is reflected in excess reserves that banks hold at the Fed. As these excess reserves decline, those once idle USDs are now put to use, resulting in improving USD liquidity in the financial system (illustrated in Chart 2).
This process has added approximately $420bn into the financial system since the beginning of the year, alleviating pressures in the Eurodollar funding market, as reflected in the 1-yr USD cross-currency basis swap.
We believe that this relationship between the US treasury and US banks excess reserves was an important driver of the current risk-on phase and is about to fade in the coming months. The driver of the ABC risk-on rally since the start of 2016 is clear on Chart 2.
The red lines indicate when the US treasury starts to rebuild cash balances and dollar liquidity starts to contract.
Followers of our work will know that we believe that the velocity of dollars drive global financial markets. The grid in Chart 4 illustrates our theory.
Outlook: Over the past two Octobers (after the higher debt ceiling has been passed), the US treasury started to rebuild its cash balances. This resulted in the excess reserves building at the Fed, tightening financial conditions again.
We believe that with the Fed commencing with the unwind of its balance sheet (September 2017), it will also contribute to the dollar shortage. In our opinion, this will lead to a tightening of global financial conditions, especially for non-US banks who will find it harder to access USDs in the Eurodollar market.
The resulting deterioration in dollar liquidity in the Eurodollar market should have significant ramifications for risk assets.