'This Is A Serious Problem': WSJ, Foreign Corporates Fret Over Dollar Funding Crisis

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About: Invesco DB USD Bullish ETF (UUP), UDN, USDU
by: The Heisenberg
Summary

I've talked quite a bit about the worsening USD funding crunch.

What I haven't done a good enough job of is explaining what the real world implications are.

On Tuesday, WSJ is out with a new piece outlining the possible repercussions.

If you read enough Heisenberg (and it's never enough Heisenberg) you know I'm not one that minds beating a dead horse every now and again if I feel like it's necessary to get the point across.

Over the summer I began to talk about the coming dollar (NYSEARCA:UUP) funding crunch in a series of well received articles including this instant classic. I picked back up on the narrative more recently here and here.

The USD shortage is getting seemingly more attention by the day and we're starting to get a feel for what it actually means in the real world as opposed to merely in the world of the theoretical which was largely how I described it some six months ago, when the weather was still bar patio friendly and thus conducive to long nights and good company.

Back then I warned that money market reform would become a reality in October, at which point hundreds of billions would exit prime funds never to return. That meant the supply of dollars readily available to fund short-term corporate debt issuance would be choked off, driving up the cost of funding and creating a USD scarcity with very real consequences.

(Chart: Credit Suisse)

That was all before Donald Trump rebounded from a rather unfortunate leaked audio clip incident on the way to steamrolling Hillary Clinton in the electoral college and talking markets out of a five standard deviation futures funk and straight into a historic run on Dow (NYSEARCA:DIA) 20,000. Part of what investors are cheering is the president elect's corporate tax reform proposal which includes plans to encourage the repatriation of hundreds of billions in cash. The problem, as I've explained at length, is that this might well further shrink the pool of available dollars, driving the cost of cross currency swaps further into negative territory and exacerbating the USD crunch.

This is also showing up in 3-month LIBOR, which recently hit 0.9634%, the highest since May of 2009.

(Chart: Credit Suisse)

So what does this actually mean? Or in other words, why should you care? Well, WSJ is out with a new piece that seeks to answer those questions and I wanted to highlight it here as I've talked so much about this dynamic but not enough about the implications. Here's an excerpt (emphasis mine):

These seemingly technical indicators are no small matter. They stand to test some of the economic assumptions underpinning the stock-market rally, because they make it more expensive for companies to finance their operations. If not matched by quicker growth, funding costs could start to weigh on an economy that has already fallen short of many analysts' forecasts.

The rising costs have been driven mostly by overhauls that require prime money-market funds to be able to bar the gates or charge redemption fees during market turbulence. The sharp flow of money out of those funds diminished demand for short-term IOUs and other debt, pushing those rates higher. Now, investors are watching to see if the economy picks up enough to withstand the impact of higher costs.

Ok, got it. See the problem there? There's no "good" way out of this. If Trump's proposals do indeed boost the economy, the Fed is going to need to catch up, which will likely mean more hikes in addition to the one that's baked into the proverbial cake on Wednesday. Indeed, market forecasts are converging on the Fed's own outlook. But as WSJ notes, "the next test of whether dollar funding costs continue to rise is a Fed rate increase."

That said, the side effects of Trump's unlikely victory (a stronger dollar and soaring Treasury yields) are set to tighten financial conditions, a state of affairs which will crimp growth. That may give the Fed more room to keep a lid on rates (presumably on the way to financing Trump's fiscal stimulus) but it's likely to be too little, too late to mitigate the mismatch between the cost of funding and the pace of growth. If the US enters a recession before fiscal stimulus can boost the economy while LIBOR remains elevated, well then corporates may have trouble financing their activities.

For foreign borrowers the situation is more dire. Here's the Journal again (emphasis mine):

Some companies turned to the so-called cross-currency basis swap market to obtain currency-hedged dollar funding by swapping funding from their own currencies. That drove up the cost of such transactions, investors say.

The three-month yen/dollar rate was at 0.79 percentage point above going rates on Monday, near its late November high of 0.91 percentage point, the highest in records going back to 2013, according to Thomson Reuters. The three-month euro/dollar rate was at 0.61 percentage point, also near its highest since 2012.

That has affected firms such as Netherlands-based information-services company Wolters Kluwer NV. The company had €1.9 billion ($2 billion) of bonds on its books at the end of June, while 61% of its revenues came from North America, according to its June 30 earnings report.

The rise in short-term funding costs has prompted some companies to look elsewhere for funding, such as by issuing longer-term dollar-denominated bonds. The amount of so-called Yankee bonds, debt sold in the U.S. by foreign entities, has surged to $930.5 billion this year, already an annual record in data going back to 1995, according to data provider Dealogic.

Japanese financial institutions, including insurance companies, have raised $42 billion by issuing dollar-denominated bonds in 2016, also the most on record for a single year, according to Dealogic.

"Increasing costs of dollar funding is a serious problem," said Hidetoshi Ohashi, chief credit strategist in Tokyo at Mizuho Securities. "Each firm is scrambling to secure funding," he added.

See what I mean? This is why I started pounding the table on this months ago. We've got ourselves a real (and growing) problem here and at least part of that problem is going to be exacerbated by Trump's corporate tax reform. Meanwhile, expectations for enhanced domestic growth could prompt the Fed to raise rates more quickly thus making financial conditions tighter even as the policies that are supposed to bring about said growth may not come fast enough to avert a recession.

It's not so much that the President needs to be able to verbalize all of this on command, but he needs to be able to absorb and understand it - count me skeptical.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.