Why a Strong Dollar Indicates Continued Stress in the Financial System

Includes: FXY, UUP
by: Darrel Whitten

With over US$8 trillion committed by the US government and the Federal Reserve in various programs to keep the financial system functioning, a US$787 billion stimulus package already passed, and an imminent bank rescue package that ostensibly start at $500 billion and be expanded to US$1 trillion, the Chinese (as the largest foreign holders of US treasury securities) are rightly worried about the value of their "loans" to the US, in the form of US$727 billion holdings of US treasuries (up 52% YoY) as of December 2008. Yet the USD and US treasuries have remained bouyant despite bear calls for a substantial sell-off in both. Generally, the strength is attributed to "safe haven" buying. As far as the USD is concerned, the reality is probably more like distressed buying.

In the March 2009 BIS Quarterly Review ("The US dollar shortage in global banking"), Patrick McGuire and Goetz von Peter analyze why the USD has strengthened in the face of the global financial crisis. Basically, this strength is a reflection of continued financial system stress.

According to the BIS data, banks' foreign positions surged from 2000, with the outstanding stock of BIS reporting banks' foreign claims growing from $11 trillion at end-2000 to $31 trillion by mid-2007. Continued large US balance of payments deficits were like a huge ATM for the global financial system, providing an abundant supply of USD. This acceleration coincided with substantial growth in the hedge fund industry, the emergence of the structured finance industry, and the spread of "universal banking". The growth of European banks' global positions was particularly noticeable. USD-denominated positions accounted for over half of these banks' overall increase.

These "long" USD positions were funded primarily by borrowing in domestic currencies. European banks' combined long USD positions grew to more than $800 billion by mid-2007, funded by short positions in pounds sterling, euros and Swiss francs. As banks' cross-currency funding grew, so did their hedging requirements and FX swap transactions, according to the BIS research.

But the freezing up of credit markets from October 2008 after the failure of Lehman Brothers suddenly meant that these banks were unable to roll over their short-term funding positions, requiring the banks to deliver foreign currency and forcing them to sell or liquidate assets earlier than expected. This created a substantial USD funding gap. The global credit squeeze tightened like a vise, threatening the viability of banks from Iceland to Belgium.

The BIS paper estimates that the European banks' USD funding gap reached $1.1 trillion~$1.3 trillion by mid-2007. Until the crisis, the European banks were able to meet their USD funding gap by tapping the interbank market and by borrowing from central banks, and using FX swaps. As interbank lending froze, FX swaps became dysfunctional and non-bank sources of funds dried up, the global financial system faced a potential wholesale run on the banks.

Seeing this funding gap threatened the very viability of the global financial system, the Fed and its central bank peers cobbled together a coordinated policy response to provide USD to banks outside the US. As the scramble for USD reached crisis proportions, the Fed's swap lines with the ECB, Bank of England and the Swiss National Bank became unlimited in order to accomodate any quantity of USD borrowing against collateral.

Since the height of the crisis, European banks' net USD claims on non-banks have declined by some 30%, and while the worst of the funding crisis has apparently passed, the USD index has remained strong, which indicates that heightened credit risk concerns, crippled short-term funding and efforts by European banks to plug huge holes in their balance sheets continues to produce strong demand for USD.

An estimated JPY20 trillion (USD204 billion) reversal of yen carry positions that rocketed the yen to near-historical highs in the mid-JPY80/USD range early this year was a symptom of this critical USD funding shortage. But while the passage of majority of this unwind in addition to seasonal repatriation of funds by Japanese investors has removed fund-flow support for the yen, USD continues to be well-supported.

From this standpoint, one of the earlier signals of an "all clear" sign regarding the global financial crisis could be a significant sell-off in USD, which in turn would put downward pressure on US treasuries. While the US can probably depend on the loyalty of Japan as the second largest owner of US treasuries (at $626 billion), one cannot help but wonder how the Chinese would react to seeing the value of their "loan" to the US substantially depreciate.