Monday, October 19, 2009
The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off].
Is he right?
I have argued that the new dollar carry trade could very well unwind during the next crash, which could create an enormous need for dollars.
Now, Tyler Durden has written a must-read summary of a new report by BIS which shows that the real liquidity crisis last year was among European banks, which were hugely overexposed to the dollar (in amounts many times greater than their GDPs, in some cases), and so they were desperate to raise dollars last year when the market crashed.
The Fed became the world's lender of last resort, extending huge swap lines to foreign central banks so they would have dollars to be able to cover their currency positions.
Durden quotes from the BIS report:
The severity of the US dollar shortage among banks outside the United States called for an international policy response. While European central banks adopted measures to alleviate banks’ funding pressures in their domestic currencies, they could not provide sufficient US dollar liquidity. Thus they entered into temporary reciprocal currency arrangements (swap lines) with the Federal Reserve in order to channel US dollars to banks in their respective jurisdictions (Figure 7). Swap lines with the ECB and the Swiss National Bank were announced as early as December 2007. Following the failure of Lehman Brothers in September 2008, however, the existing swap lines were doubled in size, and new lines were arranged with the Bank of Canada, the Bank of England and the Bank of Japan, bringing the swap lines total to $247 billion. As the funding disruptions spread to banks around the world, swap arrangements were extended across continents to central banks in Australia and New Zealand, Scandinavia, and several countries in Asia and Latin America, forming a global network (Figure 7). Various central banks also entered regional swap arrangements to distribute their respective currencies across borders.
The analysis shows that between 2000 and mid-2007, the major European banking systems built up long US dollar positions vis-à-vis non-banks and funded them by interbank borrowing, borrowing from central banks and FX swaps. We argue that this greater transformation across counterparties in fact reflected greater maturity transformation across these banks’ balance sheets, exposing them to considerable funding risk. When heightened credit risk compromised sources of short-term funding during the crisis, the chronic US dollar funding needs became acute, particularly in the wake of the Lehman Brothers bankruptcy.
Durden notes that this same currency imbalance may be rebuilding:
We are now back at a time when the only gains in the stock market are at the expense of dollar destruction, with a concomitant funding for dollar denominated assets. In one short year since the collapse of Lehman we have gone back to the same dollar funding risk exposure as was on the books in these days before Dick Fuld's empire unraveled. While whether or not the Federal Reserve stepped beyond its bounds in practically bailing out not just Goldman Sachs, but as this paper has proven, virtually the entire world, is not up to us to decide. However, a critical topic is have we learned anything from the implications of an unprecedented dollar funding gap, which is likely back to record levels once again.
As the H.4.1 discloses weekly, the Fed's liquidity swaps are now back to almost zero. This means that foreign Central Banks believe that have the FX swap and dollar maturity situation under control. They thought the same before Lehman blew up. And they were wrong. As the DXY continue tumbling every lower to fresh 2009 lows, the trade de jour is once again the dollar funding one, although unlike before when the Yen was the carry currency of choice, this time it is the dollar itself, positioning banks for the double whammy of not just a dollar funding shock, but one coupled with a potential massive short squeeze. If and when an exogenous event occurs, not even a trillion in Fed swap lines will be sufficient to bail out the world economy. It is time someone in Congress asks the Chairman all the pertinent questions that evolve from this analysis and how he is prepared to handle its next, much more vicious, and likely terminal, iteration.
I asked Durden whether he thinks the BIS report proves that Bloom is wrong, and whether he thinks the dollar will rally at the next market crash.
Depends where in the circular argument you catch the dollar. I think the take home message from the above article is actually simple: if the global CB system nearly collapsed due to dollar funding concerns when the dollar was not the carry currency, imagine what will happen when you have a dual quest for funding: 1) from structural asset/currency mismatch and the FX swap's propensity to evaporate when most needed; and 2) from the need to cover the shorts that themselves are allowing the funding of US denominated assets (it takes a while to filter through). What has happened is that we are doubly on the hook now to the Fed to provide perpetual dollar funding to anyone who needs it.
As to a direct answer, I think the next market crash will be critical whether it is a liquidity, counterparty or simply driven by momentum with everyone unwinding at the same time (Oct 19, 1987). If it is a combination of all three, the Fed will be unable to restore the system, absent it printing several dozens of trillions of dollars overnight which would devalue the entire dollar denominated asset base (which accounts for roughly 400% of Europe's GDP).
I have written to David Bloom, but am still waiting for a response.