This isn’t all that complicated.
That’s how we kicked off an October 19 post called “Revisiting The ‘Vicious’ Dollar Shortage Cycle“.
As far as I can tell, that was the latest post among dozens we’ve penned this year documenting dollar shortage dynamics, although it’s entirely possible there are more recent installments – our archive search feature is admittedly subpar and it seems like we write some riff on the dollar funding squeeze theme at least once a week.
Anyway, the quote excerpted here at the outset refers to the fact that while “dollar liquidity shortage” sounds like a topic that would be inherently complex, it really isn’t all that difficult to understand. Nomura’s Charlie McElligott has a fun formula that captures this pretty succinctly:
Fed normalization + increased Treasury supply + higher cost of borrowing in money-markets / an accelerated year-end “funding squeeze” = lower USD liquidity = enhanced cross-asset volatility.
That’s pretty much the long and the short of it, although we’ve tried, at various intervals this year, to make it sound as complicated as possible in keeping with our penchant for long-winded diatribes.
The first part of that equation references the fact that Steve Mnuchin is flooding the market with Treasury supply (to finance the stimulus) at a time when the Fed is pulling its support, which means more of the onus falls on private, price sensitive investors to absorb the deluge. As the RBI’s Urjit Patel lamented in an Op-Ed for FT, if the Fed doesn’t calibrate the pace of its balance sheet rundown to take account of increased Treasury supply, “Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”
Meanwhile, Fed hikes exacerbate the situation and as you might recall, the “year-end” funding squeeze showed up at the end of the third quarter this year, taking some folks by surprise (or at least it seemed like some people were surprised). Late in September, hedged Treasury yields turned negative for European and Japanese investors, a state of affairs that garnered quite a bit of attention.
That situation hasn’t abated and some think it could get materially worse into year-end as a result of the new regulatory regime which incentivizes dollar hoarding on Wall Street.
“We attribute the largest increase in USD funding pressures to dealer and bank balance sheet constraints stemming from key year-end regulatory reporting snapshots, the most relevant amongst these is the global systemically important bank (GSIB) surcharge”, BofAML’s Mark Cabana wrote, in a November 9 note, before explaining what’s going on here as follows:
The GSIB surcharge represents capital that bank holding companies are required to hold due to the greater potential risk they pose to financial stability. US GSIBs are bound by the method 2 scoring which captures 5 metrics: year-end values of size, interconnectedness, complexity, cross-jurisdictional activity, as well as average daily amounts of short-term wholesale funding. According to the most recent data at the end of Q2, our banking team estimates that several US GSIBs were tracking relatively high within their surcharge score ranges and have likely needed to reduce some capital markets activity (Exhibit 1).
Here’s the three-month cross-currency basis for the euro and the yen, for reference:
Hopefully, we won’t see a repeat of what happened last year (observable in the chart by the dramatic spike lower/wider during the last weeks of December), but you never know. There are concerns that further market turmoil could make banks even less willing to lend dollars than they already would have been at year-end.
It’s also possible the plunge in oil prices could exacerbate the situation further still. “As oil prices rise, petrodollar balances around the world rise [and] oil-producing nations then recycle their excess US dollars back into the US economy or into the offshore dollar banking system”, Nedbank’s Neels Heyneke and Mehul Daya wrote, in a November 14 note. “From this perspective, the financial system would be flooded with US dollars, leading to a weaker US dollar and easier financial conditions [but] the opposite is true as well”, the add.
All of this shows up in and otherwise ripples through money markets, something we’ve been documenting for months. Although things calmed down after the Q1 freakout, there are lingering/ongoing/renewed signs of strain:
Again, the question headed into year-end is how this dynamic will play out in the event risk aversion continues to rise.
Belabored efforts to dovishly interpret Clarida’s CNBC comments and Wednesday’s MNI Fed pause trial balloon notwithstanding, a December hike still seems like a lock and presumably that will only make this issue worse.
Anyway, something to ponder.