Meyrick Chapman is the principal of Hedge Analytics and a former portfolio manager at Elliott Management and bond strategist at UBS.
Apparently, Pixar wanted the movie Toy Story to show that “toys deeply want children to play with them”. A bit like the dollar, the world’s most important financial toy.
Since 1970 custodians of the dollar allowed anyone to play with it. But now Jay Powell is in the role of Sheriff Woody, and is determined his dollar toys stay home. These toys have been kicked around the financial playground for well over a generation, so Sheriff Powell’s intervention won’t be as fun as Toy Story.
US bank balance sheets have changed a lot lately, with more to come. Monetary tightening – particularly ‘quantitative tightening’ – reduces financial liquidity (cash and securities on the balance sheets of commercial US banks) while traditional credit (loans) increase.
That is largely a switch of identity on the balance sheet. But more loans act as cushion to the monetary tightening for US citizens. For the first time in decades the central bank policy favours ordinary Americans over financial markets. About time too!
If the news is not all bad for Americans, the same cannot be said for foreign dollar balances. Reduced financial liquidity hurts financial assets. And as loans dampen the effect of monetary tightening on inflation, further asymmetric impact on financial assets can be expected, because more rate rises are needed.
You don’t have to look far to see the market effects.
Not just equity and bond prices, which are the most talked-about consequence of Powell’s tightening. Turnover in US securities markets is down, by a lot. Bid/offer spreads are wider in major markets. Hyperactive monetary policy led to massive shifts in short-term rates in Europe and elsewhere, but 2022 volumes in non-US short-term interest rate futures markets are down compared to 2020 and 2021. Other markets have also seen declines in turnover.
Much can be explained as a transition away from Libor and a move to risk-free rates – usually some form of repo rate. But this just highlights the central role of the dollar as collateral and liquidity provider-of-last-resort. Dollar swap lines with the Fed are becoming a nice-to-have accessory.
In one way or another, Fed policy appears to signal the end – or at least the radical curtailment – of the Eurodollar market.
The writing has been on the wall since the global financial crisis. However, the implications only became apparent once the Fed started to aggressively tighten policy. Now the non-domestic dollar edifice may face real problems.
Back in March 2021 the UK Financial Conduct Authority made the formal announcement of the death of the reference rate for the Eurodollar market.
The FCA has confirmed that all LIBOR settings will either cease to be provided by any administrator or no longer be representative:
– immediately after 31 December 2021, in the case of all sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and
– immediately after 30 June 2023, in the case of the remaining US dollar settings.
But in reality, the market has already shifted. This chart shows how the risk (DV01) of the most representative point on the US swaps curve (7-10 years) has shifted completely to OIS pricing in the last year.
Victims are certain among the numerous eurobond borrowers of dollars whose outstanding value amounts to more than 10 per cent of global GDP.
Many are developing countries who will find it difficult to manage the combination of higher rates and stronger dollar, on top of slower economic growth. Many of the same borrowers received opaque and expensive loans from China via the Belt and Road Initiative.
It’ll be a mess.
Other unfortunates may emerge in the international money managers and global non-US banks.
Regulations have restricted banks’ market-making activities The assumption that large asset managers will step in to provide liquidity fails to acknowledge that these companies have no direct access to the Federal Reserve, and depend on transactions in financial products for their income – which are declining. The notion that the Fed would provide liquidity for fund managers is probably fanciful.
Large foreign banks often openly announce their reliance on foreign dollar balances by denominating the financial statements in dollars. A glance at their financial statements offers the usual caveats on future performance. But among the risks listed (including Climate Change, market risks, regulatory change) there is no acknowledgement that access to global dollars may change, with unpleasant implications for funding.
Toy Story included a sub-story of Sid, the nasty kid next door who amuses himself by mutilating his neighbours’ toys. Sid is eventually humiliated by Woody whose parting words warn Sid that “from now on you must take good care of your toys. Because if you don’t, we’ll find out, Sid. We toys can see everything. So, play nice.”
The original eurodollar market began in London, a city that since 1970s produced a lot of financial Sids – dollar transformation trades ultimately dependent on access to dollar funding. No surprise then if among the victims of Sheriff Powell is London as a financial centre. The recent LDI debacle was really a local representation of scarce liquidity. The episode may be a warning of what comes later if the screws really tighten.
There are lots of Sids in this Toy Story. Many of them, including London, may find comfort in the central bank swap lines that disperse dollars in extremis. The ECB is fortunate that it has agreed its own Fed swap lines. But possibly the principal, if inadvertent, long-term Sid is the Chinese development model.
Since the time of Deng Xiaoping, China relied on an umbilical relationship with the dollar to develop its economy. But now China is a target of State Department ire. Last week’s announcements on chip export controls show the definition of “national security” now includes advanced technologies, not just military capability.
While high inflation persists the restriction of offshore dollars has a cover story, but it makes geopolitical sense that monetary control be aligned with trade control. It really does look like the fun may be over.
Oh, and China does not have a swap line with the Fed.