Global Dollar Crisis No More With Central Banks Relying Less On Fed Backstop

The global US dollar crisis, a hallmark of the early events of the coronavirus pandemic, seems to have passed, with the latest milestone of a remarkable turnaround in financial situations engineered by the Fed Reserve and other major central banks.

Fed data last week showed that its peer banks from around the world have asked It for the fewest dollars in almost 3 months. It was the major factor that drives a surprise decrease in the $7 trillion balance sheet of the Fed— the very first drop since February and the biggest since the fading days of the financial crisis more than 10 years ago.

The Balance Sheet of Fed Shrinks

The Fed’s foreign exchange balance swaps with other central banks have decreased by $92 billion from June 17 to $352.5 billion from the $444.5 billion in the earlier week. The total amount outstanding in swap lines, which were designed to relieve the surge in demand for the US currency in the jurisdictions of the participating banks during the early weeks of the pandemic crisis, was at the all-time lowest since early April.

Combined with other indications of falling demand for the Fed’s emergency liquidity establishments, this reduction in the usage of the currency swap line is a sign that the global financial markets are now returning to near-normal after being overturnedby the COVID-19 outbreak in the first 2 and 3 months of the year.

During that period, the stocks dropped into a bear market at record speed, demand for greenbacks overseas surpassed supply, and risk premiums in credit markets expanded, making the US dollar unbearably expensive for foreign companies and governments with dollar-denominated liabilities.

Fortunately, the Fed quickly acted to restore order in addition tothe facilities aimed at US markets, expanded the currency swap line agreements to 9 central banks along with the 5 that already had standing agreements.

The US rates strategy analyst of NatWest Markets, John Roberts said that the restored health of funding markets and the swap lines serving as a backstop, the handoff from the central bank liquidity to the market is quite uneventful.

However, the drop off from there might be quick. A Citigroup economist noted to expect a more rapid decrease over the coming months since most of the swaps will immediately roll–off.

The Dollar Crisis Is Over

In addition to the reduction in the swap line usage, a few of the emergency facilities of the Fed have seen dropping demands in the past few weeks. The outstanding balances in programs thatare providing credit to major dealers, money market mutual funds, commercial paper issuers, and direct loans to banks in order to meet the reserve requirements have all fallen sharply or plateaued since May.

The most symbolic of the turn is perhaps the plummeting in demand for repos or repurchase agreement. Amounts outstanding in such short-term funding deals between the Fed and commercial banks are at their lowest since last September when the cash-squeeze forced the central banks to pump billions of dollars to the market.

By mid-March, this repo squeeze blew up onto the scene again as state after state issues mass closures of non-essential organizations and businesses and stay-at-home orders in the attempt to control the COVID-19 spread.

The Fed has recorded a repo balance of almost $442 billion on March 18. However, on June 17, this balance dropped to $79 billion after the 1-week decrease of $88 billion. This was the lowest since mid-September when the Fed was forced to intervene in this market.

The managing director of Credit Suisse, Zoltan Pozsar noted last week that if the foreign banks no longer require the US dollarsthey acquired from the swap lines and stop lending via the FX swap market, the Fed will definitely be there to step in with repo facility.

Repo Demand At Its Weakest

The declining demand has come as markets have regained their balance after the big swoon of the pandemic crisis. Stocks have already recovered at least 90 percent of their losses. In addition, companies are already raising capital in the bond market at such a fast pace and the risk premiums in corporate bonds yields are not back to whether they were since early March.

The dollar funding costs have already normalized. For investors in Europe and Japan, whose central bank providers were the biggest clients of the Fed swap lines since the 3rd month of this year, the cost to access the greenbacks in order to fund traction is also back to where it was in late February.

A potential advantage to the waning dollar-funding pressures is that it makes US assets like the Treasuries more appealing, which could help support the demand for US government bonds amidst the record-breaking $3 trillion borrowing binge by the current US administration in order to fund the pandemic relief efforts.

Also, the cheapening of US funding has also made it more attractive for the foreign investors in order to buy long-dated US Treasury bonds. This is one measure that could support foreign demands for the US Treasuries.