What will end the US dollar (USD) bull run?
By David Belle
13:34, 15 July 2022
Let’s face it…
Over the last 18 months, it has certainly paid to be a dollar bull, whilst everything else has fallen to pieces (it seems).
Here’s a chart of the dollar index (DXY) (but do remember the dollar index is 57% euro.
This scramble for dollars has set the scene for the equities downturn too, and the USD’s value is not simply down to rate differentials between the US and other economies, but is a factor of tightening liquidity.
A little measure you can use to show this is looking at 3-month USD LIBOR (no, it’s not defunct yet!) which is essentially the rate at which banks lend dollars to each other.
What do you notice here?
Well firstly, it’s probably key to note its increase since the start of the year, right?
Secondly, it’s important to note that when it pushes up high enough, the reduction in USD liquidity it causes tends to break something.
You’ve got the DotCom crash in 2000 and subsequent recession, the global financial crisis in 07/08, Eurozone debt crisis in 09/10 and then the dreaded COVID pandemic (I think a recession was going to happen in 2020 anyway, but that’s for another day), where LIBOR has increased fairly rapidly, alongside the dollar.
The moves in USD/JPY and EUR/USD recently have primarily been driven by a broad dash for USD, with the Yen side specifically being driven by the market testing the BoJ's resolve at the 0.25% 10-year yield cap (yield curve control) and the ECB flirting with rate hikes leading to the Bund/BTP spread widening.
In both cases, what we are looking at is the effects of a tightening regime, and increasing credit risk, with the BoJ perhaps having to shift their 'pinned' level higher and the ECB with the traditional issues of fragmentation occurring (see sovereign debt crisis in the early part of the last decade), something I mentioned here.
We can use logic here to say that this liquidity drain is down to tightening, and more specifically, a desire for investors to be compensated more for holding risk - if interest rates are higher and you can get a better risk free return, why would you hold riskier equities or junk graded debt for example?
What is your sentiment on USD/JPY?
This is known as the risk premium, and when that increases, yep, risk assets go down.
But comprised in this is liquidity premium too - how much more you have to be compensated for holding or lending something which is pretty illiquid. And that’s what we are seeing with the increase in LIBOR, the interbank lending rates.
Everyone is looking to keep hold of their dollars - dollar markets become more illiquid - the rate demanded by dollar holders to lend it out goes up.
This is important for our belief behind what will end this dollar bull run!
Let’s now introduce a mechanism called central bank FX swaps. They are just as boring as they sound, but important.
Federal Reserve use of swaps
What we can see here is that at times of severe stress, the Fed uses swap lines to keep markets functioning, and to allow credit to flow more freely, since the dollar runs the credit markets of the world.
Naturally, this is to protect the banking sector and economies - contagion is not desirable.
Back in March 2020, they created the FIMA Facility, and that became a standing arrangement in July 2021...
Some details on that...
The Federal Reserve established a repurchase agreement facility for foreign and international monetary authorities (FIMA Repo Facility). By creating a backstop source of temporary dollar liquidity for FIMA account holders, the facility can help address pressures in global dollar funding markets that could otherwise affect financial market conditions in the United States. Its role as a liquidity backstop also helps to support the smooth functioning of financial markets more generally.
The FIMA Repo Facility allows FIMA account holders, which consist of central banks and other international monetary authorities with accounts at the Federal Reserve Bank of New York, to enter into repurchase agreements with the Federal Reserve. In these transactions, approved FIMA account holders temporarily exchange their U.S. Treasury securities held with the Federal Reserve for U.S. dollars, which can then be made available to institutions in their jurisdictions. This facility provides, at a backstop rate, an alternative temporary source of U.S. dollars for foreign official holders of Treasury securities other than sales of the securities in the open market. A temporary FIMA Repo Facility was established March 31, 2020, and the facility was made a standing facility on July 28, 2021.
So how is the USD bull run likely to end?
Treasury data on U.S. foreign holdings reinforces this impression: Nearly two-thirds of international U.S. debt is held by countries with dollar swap lines.
It is also worth noting that the five pre-existing swap lines covered every G-7 country, where volatility could have serious implications for the worldwide economy regardless of their direct relationships to the U.S.
However, 200 (mostly central banks) have FIMA accounts, with the big difference being that rather than using their own currency to swap for USD, they use their US Treasury holdings.
This makes it easier to liquify the world with USD and solve the problems of credit contagion versus previously.
Using logic again, we could argue that once we start hearing more about the facility being used, more economies globally will have access to dollars, meaning the price of USD decreases.
And guess what…
The New York Fed’s research arm, Liberty Economics, mentioned the FIMA facility on Monday…
Looking at our model from the guys over at Quant Insight, it is likely the FX pair to benefit most from this will be USDJPY.
The chart below (orange line) shows the large deterioration in USD liquidity over the last year or so.
But you don’t need to look at this to see that there’s likely a big mean reversion in store for yen.
We can just look at a price chart.
US dollar vs Japanese (USD/JPY) yen price chart
A market that is approaching a 23 year high probably has some good risk to reward going the other way.
Markets in this article
US Dollar Index