ADVERTISEMENT

Global Dollar Funding Shortage, Back on Radar, May Yet Get Worse

There are several forces at work that are raising the expense of financing in dollars.

Global Dollar Funding Shortage, Back on Radar, May Yet Get Worse
A man dressed as a businessman, holds a briefcase covered in U.S. dollar notes. (Photographer: Simon Dawson/Bloomberg)

(Bloomberg) -- Signs of global dollar-funding pressures are bubbling up in currency derivatives, making it costlier for international investors to protect against swings in the greenback when they buy U.S. debt.

Cross-currency basis swaps, which money managers and corporate treasurers outside the U.S. can use to borrow in dollars, remain close to the widest levels since January even after quarter-end, when such financing strains typically dissipate. The market was a key indicator of stress during the financial crisis, and while it’s nowhere near the alarming levels of that era, it’s still garnering the attention of analysts.

Global Dollar Funding Shortage, Back on Radar, May Yet Get Worse

There are several forces at work that are raising the expense of financing in dollars. Strategists cite the political tension in Spain related to Catalonia’s independence push and the slow pace of Brexit talks, which may be heightening the perception of credit risk for the region’s banks. Combine that with the prospect that a U.S. tax overhaul could trigger dollar repatriation, and the outlook for monetary-policy divergence with the Federal Reserve starting to unwind its balance sheet, and analysts see the trend only worsening.

“This is keeping a lot of people feeling uneasy,” said Gennadiy Goldberg, an interest-rate strategist at TD Securities in New York. “This now seems more of a political story, with Catalonia, U.K. Brexit negotiations and potential U.S. tax reform and repatriation. Spreads could keep widening.”

Investors and companies use the swaps to exchange foreign-currency funding into loans denominated in dollars. As the spread becomes more negative, it swells the premium for procuring dollar financing.

While Republican efforts to get a tax plan through the Senate may be off to a rocky start, any framework that spurs U.S. companies to repatriate cash could compound the scramble for dollar financing. Although that’s probably a story that will play out in the second quarter, it may already be factoring into expectations, Goldberg said.

There’s another reason the strain is set to grow. The Fed is set to boost the pace of its balance-sheet rolloff each quarter, potentially putting upward pressure on U.S. rates relative to Europe and making it tougher for global investors to get dollar funding, according to Mark Cabana, head of U.S. short rates strategy at Bank of America Corp.

Global Dollar Funding Shortage, Back on Radar, May Yet Get Worse

The swaps movement could crimp global demand for Treasuries at a crucial time, with the Fed shrinking its portfolio and U.S. deficits projected to widen.

For Japanese investors who hedge currency risk, yields on 10-year Treasury notes fell to 0.34 percent last week, the lowest level of 2017 and down from over 1 percent in February and March. It’s still more appealing than it was in mid-2016, when dollar funding markets got so tight -- and Treasury yields so low even on absolute basis -- that hedged 10-year yields turned negative for Japanese buyers.

Global Dollar Funding Shortage, Back on Radar, May Yet Get Worse

Credit instruments are also affected. Overseas investors have gobbled up U.S. corporate debt, leaving that market more vulnerable to currency volatility. International buyers own about $3.6 trillion of U.S. company borrowings, a $600 billion increase in the past two years, according to Wells Fargo & Co.

"The recent period of dollar strength alongside tighter spreads has drastically reduced relative value for global investors into USD credit," Wells Fargo strategists led by Nathaniel Rosenbaum wrote in a research note this week. Hedging costs, as implied by the currency-forward market, are higher month-on-month for all but two of the 15 currencies the bank tracks.

No-Brainer, No More

For euro-based investors, the spread on five-year U.S. investment-grade bonds over Treasuries, accounting for hedging costs, has shrunk below 20 basis points, from over 60 basis points in April, Wells Fargo analysis shows. In other words, for yield-starved euro investors, the no-brainer trade -- simply snapping up dollar credit -- is no more, leading them to take on more duration and credit risk to juice returns.

Another measure of dollar-funding costs has yet to show the same stress. The gap between dollar Libor and overnight index swaps -- an indication of traders’ expectations for the fed funds rate -- has been narrowing, showing easier bank-funding conditions.

Global Dollar Funding Shortage, Back on Radar, May Yet Get Worse

That should change next year as the Fed’s portfolio reduction speeds up and if Congress agrees to resolve the U.S. debt limit, allowing the Treasury to build its cash buffer. The combination will worsen dollar-funding strains more broadly by shrinking excess reserves and tightening monetary conditions.

“We aren’t expecting much additional pressures over the course of this calendar year, but think we can see them increase a bit when we get into next year,” Cabana said. The impact from Treasury’s cash-balance movement and the Fed debt rolloff “will be quite significant and will result in overall funding pressures.”

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net, Brian Chappatta in New York at bchappatta1@bloomberg.net, Sid Verma in London at sverma100@bloomberg.net.

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Samuel Potter at spotter33@bloomberg.net, Mark Tannenbaum, Boris Korby