In this piece, RocSearch discusses various factors contributing to the US dollar liquidity, arguing that those factors have undergone a structural change in recent years. We also highlight the US Federal Reserve’s stance on future rate hikes amidst continued squeeze in dollar liquidity conditions.
TEST BANK For Corporate Finance, 13th Edition By Stephen Ross, Randolph Weste...
What's causing the US Dollar liquidity squeeze? march 11 2016
1. What’s Causing the
US Dollar Liquidity
Squeeze?
White Paper
Amongst many, one of the most prominent
concerns regarding the global financial markets
in 2015 was the strengthening of the US dollar,
accompanied by the tightening in its liquidity
conditions. In this article, we have discussed
various factors contributing to the US dollar
liquidity, arguing that those factors have
undergone a structural change in recent years.
We have also highlighted the US Federal
Reserve’s stance on future rate hikes amidst
continued squeeze in dollar liquidity conditions.
March 2016
2. Introduction:
In 2015, the cross-currency swap basis1
went deeper into the negative territory
(Figure 1) for most major currency pairs of
the USD for the third time2 in the last
decade. A ‘negative’ basis suggests that the
party under swap agreement that borrows
the USD (and lends another currency, say
Euro) has to pay a premium for borrowing
USD vs. Euro; thereby, implying a
tightening in the USD funding conditions.
USD is special in the sense that it’s a global
reserve currency – all the major
commodities are priced and traded in the
USD. Thus, any tightening or easing in
dollar liquidity conditions have an
enormous impact on the global economy.
In this article, we will discuss the squeeze
observed in dollar liquidity conditions in
the context of current economic
environment, describing three major
contributing factors that seem to have
witnessed a structural change.
Figure 1: 5-Year Cross-Currency Swap Basis (in bps)
The US ran large current account deficits
(Contributing Factor #1) before the crisis,
which presumably resulted in current
account surpluses in many nations, such as
China. Increased current account surplus
translated into an increase in international
reserves balance (for such nations) via
purchase of the US fixed-income assets
(mostly, the US treasuries), which propped
1 Under a cross-currency swap agreement, two parties
exchange a specific sum of money denominated in two
different currencies, with each making periodic payments
based on short-term interest rates. For instance, a party
lending Euro and borrowing USD will make periodic payments
of EUR 3-m LIBOR + ‘basis/ spread’, while receiving USD 3-m
LIBOR
up their prices, effectively lowering yields
and easing borrowing conditions.
After the global financial crisis (GFC) of
2008-09, the US Federal Reserve
unleashed the so-called liquidity bazooka
in the form of its asset purchase
programme, also known as Quantitative
Easing (QE) (Contributing Factor #2). As a
result, interest rates (yields) declined at
the long end of the yield curve3, dollar
2 First dip occurred after Lehman bankruptcy in 2009. Second,
on the occasion of Sovereign Debt crisis, and then during 2014-
15
3 A plot of yields (y-axis) versus time to maturity (x-axis) for the
fixed-income securities
-120
-100
-80
-60
-40
-20
0
20
40
60
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10
May-10
Sep-10
Jan-11
May-11
Sep-11
Jan-12
May-12
Sep-12
Jan-13
May-13
Sep-13
Jan-14
May-14
Sep-14
Jan-15
May-15
Sep-15
EUR-USD Swap Basis 5-Year JPY-USD Swap Basis 5-Year
GBP-USD Swap Basis 5-Year
3. borrowing conditions eased across the
globe and the USD value depreciated4.
Petrodollar recycling (Contributing Factor
#3) channel kept the demand up for the US
fixed-income securities (including others
such as investment grade corporate bonds,
equities, etc.), essentially putting a lid on
the yields and thereby, easing the dollar
liquidity.
A. Shrinking US Current Account Balance Reducing the USD Supply:
Prior to the GFC in 2009, the US ran large
current account deficits, paying for its
imports by providing USD to the rest of the
world. Developing countries accumulated
the USD, using it as a capital base for the
expansion of credit within their respective
domestic economies. Further, reserve
assets build-up prevented the developing
nations’ currencies from appreciating, in
effect providing a competitive advantage
for their exports.
However, post GFC, the US economy
structurally changed. It did not run the high
current account deficits it used to because
the US consumers bought fewer imported
goods and services, even when the
economy began to recover. Lower current
account deficits (Figure 2) meant that the
supply of the USD, which the rest of the
world seeked, had slowed down.
Another factor that has led to the
reduction in the US current account
balance has been the ‘Shale Revolution’.
During the 9-year period from 2005-13,
crude oil accounted for an average of 11%
of the total US imports. During this period,
the US imported crude oil worth $22 bn per
month. However, with the advent of shale
revolution, the US crude production
climbed sharply, reducing the need for
large crude imports (Figure 3). Therefore,
in contrast, in 2015, the US imported crude
oil worth $11 bn per month, which
accounted for an average of 5% of the total
US imports (2015).
Figure 2: US Current Account Balance as a Percentage of GDP
4 On a trade weighted index basis
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
Jun-96
Apr-97
Feb-98
Dec-98
Oct-99
Aug-00
Jun-01
Apr-02
Feb-03
Dec-03
Oct-04
Aug-05
Jun-06
Apr-07
Feb-08
Dec-08
Oct-09
Aug-10
Jun-11
Apr-12
Feb-13
Dec-13
Oct-14
Aug-15
US Current Account Balance as a % of GDP
4. Figure 3: US Monthly Imports ($ bn)
B. Expectations of Monetary Policy Divergence:
To pull the world out of the GFC in 2008-
09, the central banks globally came
together, orchestrating massive monetary
easing programmes to spur growth. The US
Federal Reserve and the Bank of England,
in addition to slashing interest rates to all-
time lows of 0% and 0.5% respectively,
initiated QE. In contrast, other major
economies reduced their interest rates and
adopted a highly accommodative
monetary policy stance.
As both the US and the UK economies
recovered gradually, their central banks
(US Fed and BoE) ended their respective
QE programmes, while not increasing
interest rates. Japan and the Eurozone
economies, however, were struggling to
grow and looking at the apparent success
of QE programmes decided to emulate the
success by launching their own QE
programmes5.
QE tends to depress the yields offered by
long-duration bonds; thereby, providing a
lift to their prices. In fact, the impact is not
only limited to bonds, but also
reverberates through the fixed-income
universe, including commercial real estate,
residential real estate, leveraged loans,
etc. For a fixed-income investor, though,
the yields decline is considerable. So, large
fixed-income investors, such as pension
5 Bank of Japan (BoJ) announced its QQE programme in
April’13; ECB announced its expanded asset purchase
programme in Jan’15
funds and insurance companies, often
have to invest in riskier avenues in search
for (higher) yields.
With Japan and Europe initiating QE
programmes and the US looking to start
raising rates, expectations were built,
sometime in mid-2014, for what was
termed as Monetary Policy divergence. It
basically meant that while the monetary
0
5
10
15
20
25
30
35
40
45
0
50
100
150
200
250
300
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
US Total Imports (USD bn) US Crude Oil Imports (USD bn), RHS
Impact of QE on the bond markets:
5. policies had been synchronised after the
crisis, now both the US and the UK looked
to decouple their policies from that of
Japan and the Eurozone.
This meant opportunities to earn higher
yields in the US vs. Europe for essentially
the same risks (if not higher). To illustrate,
a pension fund currently generating a 1%
return from a 10-year German Bond could
achieve a return of 1.8% from a 10-year US
treasury bond. Both the German and the
US economies are AAA rated and switching
from one to the other would not pose any
additional credit or default risk. Hence,
expectation of higher future yields seeped
into the USD value, raising it significantly
against the Yen and the Euro (Figure 4).
Figure 4: US Dollar Spot Index
C. Petrodollar Recycling:
In 1973, a deal was signed between the US
and Saudi Arabia under which all oil bought
from Saudi Arabia was to be denominated
in the USD, and in return the US offered
military support and protection from
neighbouring countries.
By 1975, all the OPEC nations agreed to
price and sell their oil in USD; thus, giving
birth to the petrodollar system. These
nations used the US dollars, thus earned,
primarily for a) financing imports of goods
and services, b) accumulating international
(foreign exchange) reserves for active
management of their pegged currencies,
and c) investing in foreign assets to
generate higher returns. By investing in
foreign assets, oil producing nations
essentially supplied the USD back into the
global financial system. Thus, the name
‘Petrodollar Recycling’. This made up for
the lack of domestic investment
opportunities, and helped these nations
earn a higher return than that earned by
placing oil revenue surplus in international
reserves. Foreign asset classes too have
enjoyed large inflows from oil producers,
which propped up their prices, while
keeping the yields lower. According to the
US Treasury Department, with $293 bn in
holdings, oil exporters are the fourth
largest holders of the US Treasuries (Figure
5).
65
70
75
80
85
90
95
100
105
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Jan-15
Jul-15
Jan-16
US Dollar Spot Index
Appreciation based on
expectations of monetary policy
divergence
Depreciation based on QE/
accommodative policies
6. Figure 5: Top 8 US Treasury Holders (2015)
Oil boom in the last 15 years, which
witnessed oil prices rising from $30/ barrel
in 2000 to over $100/ barrel in 2014,
helped oil producers accumulate and
invest a large sum of petrodollars into the
global markets. Petrodollars were recycled
into safe haven markets, such as sovereign
bonds, equities, trophy property assets,
etc. As it relates to the fixed-income
markets, these continued inflows, in part,
supported the prices, thus reducing the
yields.
However, economic environment changed
significantly over the past two years. The
North American Shale boom, accompanied
by record production by the OPEC nations,
led to significant decline in the crude oil
prices. Currently, the crude oil futures
market suggests oil prices are likely to stay
in the range of $45-$55/ barrel until 2019.
As oil revenues dry up, oil producers have
to scamper to take unpopular fiscal
measures, such as raising/ introducing
taxes, slashing subsidies and raising
domestic fuel prices to balance their
budgets. Some have even tapped into the
international bond markets to raise funds.
Amidst all this, a sharp decline in oil
revenue surplus has dried up the
petrodollars flow from the oil exporters.
According to BNP Paribas, in 2014, oil
producing nations have pulled out money
from the rest of the world for the first time
in the last decade. As per Reuters, since
May’15, Saudi Arabia sold $1.2 bn of
European equities, Norway sold $1.1 bn
worth of its holdings, and Abu Dhabi
dropped about $300 mn worth of shares
from its holdings. Hence, decline in
petrodollar seems to be reducing dollar
liquidity as oil exporters pull out their
money from the financial system as
opposed to providing liquidity by
purchasing or investing in foreign assets.
China
20%
Japan
18%
Caribbean
Banking Centres
6%
Oil Exporters
5%
Ireland
4%
Brazil
4%
Switzerland
4%
UK
4%
Others
35%
7. Conclusion:
As a result of a confluence of the factors
discussed above, there seems to be a
‘dollar shortage’ or draining of dollar
liquidity from the global financial markets,
accompanied by the US dollar
strengthening. Historically, periods of
dollar strengthening have been
accompanied by slower global economic
growth. To that end, any additional
interest rate hikes by the US Federal
Reserve not only could result in a global
slowdown, but could also cause distress
within the US economy, brought on by
weak exports, manufacturing and
deflationary headwinds via imports. We
believe that the US Federal Reserve is
aware6 of the risks a stronger dollar/ dollar
shortage poses to the world, and would
avoid raising rates at the pace implied by
the FOMC ‘Dot-Plot’ (expectations of 4 rate
hikes in 2016) as published in Dec. 2015.
Though, based on last year, it’s almost
impossible to predict the Federal Reserve’s
future actions, we expect a maximum of
two rate hikes in the best case scenario,
and no rate hikes if global growth seriously
falters.
6 Janet Yellen, Chair of the US Fed, in her testimony (Feb. 2016)
to the Congress expressed concerns about the external
economic growth, strong dollar and weak US exports sector
