European banks took advantage of more favorable terms on the Fed’s swap lines, tapping the crisis-era facility for the most funding since… well, since the crisis.
In total, take-up was $130 billion, with eurozone lenders accounting for $112 billion. UK and Swiss lenders took $15.5 billion and $2.6 billion, respectively, in the operations, announced in concert with the Fed as part of Jerome Powell’s Sunday evening “whatever it takes” moment.
Wednesday’s operations were being watched closely after a harrowing blowout in cross-currency basis on Tuesday turbocharged the greenback rally and set off alarm bells that the dollar funding crunch was worsening despite the Fed’s efforts and assurances. If you squint over there on the right-hand side, you can see the euro-dollar basis coming back in.
This comes a day after Japanese banks tapped the “new and improved” (if you will) lines for $32 billion.
“The good news in markets is that cross-currency basis levels in EUR-USD and USD-JPY have retraced the spikes wider that we saw in recent days, relative to pre-crisis levels”, SocGen’s Kit Juckes wrote Wednesday.
“This matters on a day-to-day basis for the FX market because liquidity stress, and a rush to get hold of dollar liquidity in particular, sends the dollar higher against everything, including the Japanese yen”, Juckes went on to say, adding that from “2008-2017, spikes in basis or other measures of stress came with temporary USD strength”.
“Today’s ECB swap auction saw good take-up [and] the EUR cross-currency basis… narrowed very quickly back towards zero”, ING said, in an e-mailed note, on the way to writing that while “some demand for USD funding has been satiated… it would be foolish to declare that the worst of the crisis is over [even as] the Fed deserves credit for quickly papering over the cracks appearing in Dollar money markets”.
Yes, it probably would be “foolish” to suggest that the worst is over. And, in a new note, the incomparable Zoltan Pozsar lays out some potential problems.
For one thing, the Fed needs to expand these lines beyond the G-7. This is something analyst after analyst has insisted upon over the past several weeks.
But beyond that, there’s an even deeper, more structural dynamic at play.
“The dollar funding needs of both banks and non-banks is what’s at risk and the assets that are being funded are US assets — Treasuries, MBS and credit — so the Fed has a vested interest”, Pozsar writes, adding that while the swap lines “are now active… it feels like the operational aspects of it need to be fine-tuned”.
Why? Well, for one thing, the stress in the FX swaps market suggests dollars should be offered daily, not weekly and “at ultra-short tenors as well, similar to how the Fed lends in the repo market”, Zoltan says.
But more interesting is the discussion of how the post-crisis financial order has effectively embedded more risk when dollar funding gets choked off. Here’s Pozsar:
A hallmark theme of the post-QE global financial order has been the secular growth of FX hedged fixed income and credit portfolios at non-bank institutions like life insurers and asset managers from negative interest rate jurisdictions — the new shadow banking system, epitomized by money market funding (FX swaps) of capital market lending (Treasuries and the full credit spectrum). Carry makes the world go round and as banks do more for the economy central banks will have to backstop the shadow banking system — yet again.
He then spells things out, noting that non-banks need access to the dollar auctions, and if they don’t get that, the FX swaps market could persistently trade wide unless banks are willing to serve as matched-book intermediaries.
And so, the bottom line from Zoltan is as follows:
There is a growing risk that such intermediation will fracture as the assets that FX swaps fund include not only Treasuries but credit and CLOs too. Credit quality is fast deteriorating across various sectors and that makes it riskier for dealers to fund some life insurers through FX swaps, just like it became riskier to fund some insurers during the 2008 crisis. Over the past five years balance sheet and the availability of reserves were the main drivers of spreads in the FX swap market. It’s time to think about credit risk creeping in to funding markets through the asset side of some portfolios funded through FX swaps.
Something to think about, even as the Fed continues to play catch-up, most recently on Tuesday evening with the reinstated primary dealer credit facility.