The imminent round 2 of the foreign bank dollar funding crisis, or the EUR/USD squeeze redux

The Federal Reserve’s dollar liquidity swap extensions saved foreign banks in H2 2008, particularly in Europe, as foreign bank balance sheets faced big losses in USD-denominated securities, with no recourse of injecting new dollar liquidity to stem the tide of collateral demand, as well as rush to liquidity/safety.

Dollar Liquidity Swaps vs Dollar Index

This had clear implications on the global supply/demand dynamics of the US Dollar (as is evident in the chart above [source: Federal Reserve H.4.1). But now the swaps are back to about zero and global deleveraging has not yet wiped out all malinvestment, especially considering the inflated marks on financial balance sheets globally.

The ramification of zero liquidity swaps to draw upon is that foreign banks now have no excess supply of USD (indirectly, through their respective central banks) to use for filling funding mismatches if another round of deleveraging, counterparty risk heightening, and liquidity chasing returns.

As the chart below (source: Bank of International Settlements– Detailed tables on provisional locational and consolidated banking statistics at end-September 2009– Table 5A) shows, global bank balance sheet deleveraging, adjusted for the currency’s proportion of total denominations, has been very muted in the dollar relative to other currencies.

Global Bank Balance Sheet Deleveraging

Given the crisis risks going forward in commercial real estate, sovereign debt (particularly eastern Europe, PIIGS, Dubai/UAE, UK, etc), and alt-A/option ARM, we find it hard to believe that foreign banks will not need a second round of liquidity swap line extensions by the Federal Reserve.

Of course, such a move would be reactionary in nature, meaning a sharp unwind in the form of a eurodollar squeeze sending the USD surging (in the short term, before the Fed’s swap lines are re-instituted) would materialize.

The big variable going forward, however, is the emergence of the dollar-funded carry trade. Now, instead of just two demand-oriented variables driving the dollar funding mismatch (deleveraging and flight to safety), a third unwind exists in the form of the ultra-crowded USD carry trade. The emergence of non-USD reserves in central bank balance sheets confirms the uber-short position the world effectively has on USD. Once deleveraging round two commences, this carry trade is an enormous position that will face a sharp unwind, further amplifying the effect on USD exchange rates, like in July 2008 to January 2009.

The liquidity swaps are evaporating just as QE liquidity dries up here in the United States. The excess globally (and domestically) injected supply of dollars that drove assets up in 2009 and the USD down are all but gone. But the debt has a long way to go before being completely purged. The implication here is that an exogenous event (several of which are popping up every day again) driving a rush to USD will face unprecedented amplification and unwind severity because of the added variables in the USD supply/demand (im)balance.

And as we discussed before, foreign banks have no short-term credit access when the USD rallies:

Foreign Bank CP Outstanding vs Dollar Index

If the current rally in the USD persists, the TED spread may once again widen (though the global central bank subsidization of private entity risk has effected LIBOR’s utility as a relevant metric) and the dollar carry trade unwind will experience a harsh negative convexity, which will be met with yet further unprecedented reactionary policy from the Fed.

Suggested reading:

The Global Financial Crisis and Offshore Dollar Markets: Niall Coffey, Warren B. Hrung, Hoai-Luu Nguyen, Asani Sarkar: Federal Reserve Bank of New York

The US dollar shortage in global banking and the international policy response: Patrick McGuire and Goetz von Peter: Bank of International Settlements

Detailed tables on provisional locational and consolidated banking statistics at end-September 2009: Bank of International Settlements

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