Friday, December 29, 2017

A dollar-funding problem? - Cross-currency basis swaps signal temporary dollar shortage

Global macro traders look for outliers. The good ones have a disciplined approach to review and process lots of cross-market relationships looking for the few that may be out of place. These are the relationships that need capital and for those that can provide the funds, there is a reward. 

Think of these cross-market outliers as tremors that may indicate something more going on, an indication of a greater potential financial dislocation. This is especially the case when there it may occur in markets that are supposed to be liquid like the foreign exchange markets.

International trade flows are dwarfed by the capital flows that are used to lubricate global banking and financial intermediation. When the system is working well, interest rate differentials between international and domestic markets are minimal. In a well-functioning system where there is no financial stress, covered interest rate parity holds. When there is shortage of funds in the systems, prices will signal the stress points. Debt and loan markets have exploded with strong borrowing demand. Much of this funding is still in dollars, so dollar swap funding is important to facility the flows.

The short-term cross-currency basis for many currencies has signaled stress again this year although there has been a significant snapback in the last week. The three-month basis is now similar to where it was last year after an extended divergence. The negative levels for the cross-currency basis swaps suggest that this has been another end of year of dollar shortages. Basis Lows were hit at end of November 2015, December 28th in 2016, and December 15th this year with the worst negative basis in 2008 and the end of year 2011.

There is always a certain level of window dressing and fund stresses at the end of the year, but we are concerned with these basis swap dislocations even if there are not signs of financial stress in other markets. First, we are dealing with very liquid markets. Second, basis swap dislocations are a sign of larger funding problems during times of stress. Third, and most important, the Fed tightening and balance sheet unwind will create conditions for a dollar shortfall. 

We have seen that when there is a dollar shortfall with Fed tightening, EM debt markets become stressed. While we still view EM as the place for greatest return opportunity, the cross-currency basis points to an investment tremor. Tremors are not a quake or an indication of a true market-funding shortfall, but it is a signal that is worth following.

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