A Crisis Reinforcement Channel Wakes Up

We have recently discussed the alleged “dollar shortage” with Mish and several others. The first thing that springs to mind when hearing of a “dollar shortage” is this: why should there be a shortage of a fiat currency that not only can be printed at will, but the supply of which has in fact more than doubled since early 2008?

 

HMRC-Business-Tax-Record-Checks

Photo credit: Christopher Furlong/Getty Images

 

Of course those who are in a sense short of dollars are the many dollar borrowers abroad, who need to service a $8.6 trillion debt load. Here is a chart published by the BIS we have shown previously:

 

1-BIS-dollar-credit-to-nonresidents-by-sourceStock of dollar loans issued to non-banks abroad (lhs), annual growth rate (rhs).

 

To the extent that these dollar borrowers have income that is not denominated in dollars, they may indeed be in trouble now, as the dollar’s exchange rate has relentlessly soared. This incidentally slows down the accumulation of dollar reserves by central banks in countries with a mercantilistic economic policy (since they don’t feel the need to weaken their currencies anymore).

Over time, this should work as a counterweight to the dollar’s strength, as domestic money supply growth in these countries will tend to slow down as a result. In addition, other currencies are currently beginning to replace the US dollar for new borrowings. These days the euro and the yen have become popular funding currencies – initially, this tends to exacerbate the price trends that are already in place, but at some point, the problem currently faced by dollar borrowers will migrate to euro and /or yen borrowers.

What is quite interesting is where the majority of dollar borrowers are located. Most are actually domiciled in emerging markets, the currencies of which have been especially weak. So there undoubtedly is a problem, but as we will explain below, the problem shouldn’t be termed a “shortage”.

 

2-BIS-dollar-credit-to-nonresidents-by-geographyMost dollar borrowers outside of the US are located in emerging markets

 

In the discussion alluded to above, we made the following remarks (which were in part already published by Mish), to which we add a few additional thoughts below:

The visible currency effects (such as a soaring dollar exchange rate and funding gaps, see below) are usually mainly a consequence, not a cause of crisis conditions. Of course, the recent rise in the dollar was initially triggered by perceptions of monetary policies between the US and other currency areas diverging – everybody expects the Fed to hike rates, while rates are being lowered everywhere else. It should be added to this that there are of course feedback loops at work: the stronger the dollar becomes, the more difficult it will be for dollar debtors abroad to service their debt, so any future crisis situation will tend to feed on itself. Note in this context that if a debtor has hedged his dollar exposure, the associated currency risk has not disappeared – it has merely been shifted to his counterparty.

As can be seen from the charts above, borrowing in dollars has increasingly been effected via bond issuance in recent years – however, although their share of dollar loans abroad has decreased, bank loans extended to overseas borrowers have still continued to grow. If funding of dollar assets was a problem in 2008, it would be an even bigger problem today if a crisis that once again creates major distrust among financial intermediaries were to hit.

 

A Shortage of Dollars?

There are large amounts of dollars held in deposits abroad (mostly in Europe), and fractionally reserved banks are of course lending them out. They routinely have sizable asset/liability maturity mismatches (banks do lend out money held in demand deposits after all, which is the “ultimate” maturity mismatch), but this is true of banks everywhere, regardless of the currencies employed.

Prior to the central bank swap arrangements (this is in reference to the dollar swap windows the Fed has established with numerous central banks abroad), overseas based commercial banks could not turn to their own central banks for “lender of last resort” services with respect to funding of dollar assets when dollar deposits suddenly fled (US money market funds are e.g. a major source of these dollar deposits, and they pulled back when the US mortgage credit bubble blew up).

This concern is by now academic, since the swap lines now do exist, and are theoretically unlimited. Incidentally, US taxpayers have not suffered any harm, as all the swaps have been paid back (and even if they hadn’t been paid back yet: no-one was actually “taxed” to create them. The money was created from thin air, with the push of a button). The chart of central bank liquidity swaps below also supports our above contention: dollar funding problems in overseas banking systems are primarily a consequence, not a cause of crisis conditions.

 

3-Central Bank dollar swapsEvolution of central bank liquidity swaps – click to enlarge.

 

As noted above, the largest amount of dollar deposits held abroad is located in Europe. European banks are therefore also the biggest lenders in dollar credit transactions between non-US residents. They are also the biggest lenders to emerging markets in general, so any problems there are bound to impair the situation of European banks. In fact, three quarters of all dollar-denominated lending to non-US resident borrowers is funded with dollars held abroad – only one quarter comes directly from US lenders.

We currently see euro basis swaps trading in negative territory again, which is indeed an indication that dollar funding conditions have tightened. Shorter term basis swaps have not deteriorated as much as the longer term ones – usually, when there is really a big problem, the shorter maturities will move into negative territory at almost the same pace (this is just an empirical observation). This may yet happen with a lag though.

Something is definitely stirring though – and it happens concurrently with the euro showing extraordinary weakness and in concert with on-and-off market concerns about the situation in Greece (although we would argue these concerns are more “off” than “on”, so they may only be playing a small role. It is of course a role that harbors some potential to become bigger).

 

4-Euro basis swapsThree month, one year, three year and five year euro basis swaps -diving into negative territory again – click to enlarge.

 

As noted above, there are approximately $8.6 trillion in dollar-denominated debt outstanding abroad, a not inconsiderable amount. The basis swap “penalty” rate evident in euro basis swaps could be an indication that there is now a measure of distrust in the system: dollar lenders need to be recompensed for taking credit risk. The actuarial value of the fx basis should normally be at zero – if it isn’t, something is amiss. The main reason for the fx basis to drift into negative territory are usually concerns about the creditworthiness of banks.

Readers who want to learn more about short term swap markets can download a guide by CS (pdf) we have made available for such occasions. In addition to this, here is a recent document by JPM (pdf) that discusses the current signs of growing dollar funding difficulties (referred to as a “shortage” throughout, but we believe this is not the best choice of words. “Funding gap” is perhaps better). JPM argues that since no banking crisis is in evidence, the perceptions about diverging central bank policies must be the main reason for the developing supply/demand imbalance. We are not entirely sure about this though.

Per experience, euro basis swaps will decline deeply into negative territory before European banks will apply for funds from the Fed/ECB swap window, since the funds provided by central banks via these swaps don’t come for free either. In fact, they are relatively expensive if memory serves, which means that once one sees banks borrowing from this facility, the situation is probably quite dire already. Obviously, since the amount of central bank liquidity swaps currently outstanding is at zero, there is no evidence yet of an acute funding problem. What there is are however the first smoke signals that something of this sort could soon be afoot.

We think it is actually not quite correct to speak of a “dollar shortage” in this context. The domestic US dollar money supply has more than doubled since 2008 (in terms of TMS-2), and a sizable amount of dollar creation has “escaped” into accounts held abroad as well (read: the dollar money supply held outside of the US has also increased). It is not a shortage of dollars, but a growing unwillingness of dollar holders to lend them out that could create a problem for banks in need of dollar funding.

 

Bond Issuance vs. Bank Lending

Most of the new dollar lending to overseas borrowers has happened via bond issuance, and banks have shut down a lot of their proprietary bond trading due to new regulations and have cut back mightily on assets with a risk weighting higher than “zero” in order to comply with higher tier one capital requirements (this can sometimes backfire, as in the case of senior “guaranteed” Heta bonds). Given all this, should it not be assumed that any crisis in the context with dollar debts of overseas borrowers would be of – relatively speaking – little concern to banks?

The biggest losses would after all be suffered by investors in these bonds, most of whom are non-banks. However, this argument overlooks the interconnectedness of credit markets. Banks could find themselves affected indirectly. A borrower who defaults on a dollar-denominated bond and is forced into bankruptcy will also default on his other debts – and these will invariably include many bank loans. Many investors are in turn borrowing funds to leverage their investments in bonds. With interest rates at rock bottom levels everywhere, ample leverage is reportedly employed to juice returns.

Moreover, what is commonly referred to as the “shadow banking system” is also interconnected with banks. Losses in corporate bonds (which don’t necessarily have to stem from defaults – a rise in rates for whatever reason could already produce painful losses for leveraged investors and would set off a wave of forced selling) will reverberate across the financial system. Note that the fact that banks are no lonfer as active in corporate bonds as they once were is likely to greatly exacerbate volatility.

How things will precisely play out when the next financial crisis arrives is not knowable in advance. There are always surprises, and all we know with certainty at this point is that the next crisis will look different from the last one. For instance, even during the mortgage credit crisis several flashpoints of the crisis were undoubtedly a surprise for most market participants (think e.g. about AIG’s credit default swap portfolio blowing up – no-one expected this in advance to our knowledge).

 

Conclusion:

There are some indications that trouble could be on its way as a result of the soaring dollar. This is something that certainly requires close watching now, as one (of many) potential triggers for pricking the bubble. The main fount of bubble conditions, money supply growth, still seems to be in fine fettle for the moment, but we know that the current boom is to some extent fundamentally different from a “normal” boom, in that it is far more concentrated in financial markets, so one will have to be careful with the interpretation of various data. We will discuss this particular aspect in greater detail in our next installment of the “Echo Boom” series (coming soon). Stay tuned.

 

5-DXY

The dollar index continues to go parabolic … to the chagrin of dollar borrowers not resident in the US – click to enlarge.

 

Charts by: BIS, St. Louis Federal Reserve Research, Bloomberg, StockCharts.
 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

3 Responses to “The Dollar Squeeze – How Problematic Is It?”

  • ManAboutDallas:

    Doesn’t anyone see the similarity between the current US$ blow-off top and the one silver put in back in April of 2011?? Line up the charts, for heaven’s sake; they’re veritable twins.

    And the US$ will suffer the same fate as silver and every other parabolic, blow-off top every market experiencing such an occurrence has suffered since the dawn of markets, and blow-off tops.

    No, it’s NOT “…. different this time.”

  • No6:

    No Dollar shortage but there is a collateral shortage for all those derivatives now looking very shaky.

  • FoolsGold:

    This is one of the better pieces I have read in recent months and years regarding this issue and I want to point out that while assets lately have fallen in terms of dollars, bitcoin has not…Bitcoin has kept pace and in fact increased even as gold and silver sells off….

    The premise of Fed policy – that tech keeps up with money printing – is flawed and will feed the very problem you explain.

    https://www.goldsilverbitcoin.com/?p=5270

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Gold Sector: Positioning and Sentiment
      A Case of Botched Timing, But... When last we wrote about the gold sector in mid February, we discussed historical patterns in the HUI following breaches of its 200-day moving average from below. Given that we expected such a breach to occur relatively soon, the post turned out to be rather ill-timed. Luckily we always advise readers that we are not exactly Nostradamus (occasionally our timing is a bit better). Below is a chart of the HUI Index depicting the action since the January...
  • India: The next Pakistan?
      India’s Rapid Degradation This is Part XI of a series of articles (the most recent of which is linked here) in which I have provided regular updates on what started as the demonetization of 86% of India's currency. The story of demonetization and the ensuing developments were merely a vehicle for me to explore Indian institutions, culture and society.   The Modimobile is making the rounds amid a flower shower. [PT] Photo credit: PTI Photo   Tribal cultures face...
  • The Long Run Economics of Debt Based Stimulus
      Onward vs. Upward Something both unwanted and unexpected has tormented western economies in the 21st century.  Gross domestic product (GDP) has moderated onward while government debt has spiked upward.  Orthodox economists continue to be flummoxed by what has transpired.   What happened to the miracle? The Keynesian wet dream of an unfettered fiat debt money system has been realized, and debt has been duly expanded at every opportunity.  Although the fat lady has so far only...
  • March to Default
      Style Over Substance “May you live in interesting times,” says the ancient Chinese curse.  No doubt about it, we live in interesting times.  Hardly a day goes by that we’re not aghast and astounded by a series of grotesque caricatures of the world as at devolves towards vulgarity. Just this week, for instance, U.S. Representative Maxine Waters tweeted, “Get ready for impeachment.”   Well, Maxine Waters is obviously right – impeaching the president is an urgent...
  • Welcome to Totalitarian America, President Trump!
      Trump vs. the Deep State If there had been any doubt that the land of the free and home of the brave is now a totalitarian society, the revelations that its Chief Executive Officer has been spied upon while campaigning for that office and during his brief tenure as president should now be allayed.   Image adapted from the cover of “Deep State #5” - depicting an assassin from the future   President Trump joins the very crowded list of opponents of the American...
  • Searching for Truth
      Heresy or Truth? RANCHO SANTANA, NICARAGUA – In the fifth century, Christian scholars counted 88 different heresies. Arianism. Eutychianism. Nestorianism. If there was a way to “offend” God, they had a name for it. One group of “heretics” argued that there was no such thing as “original sin.” Another denied the trinity. And another claimed Jesus was not divine. Which one had the truth?   Depiction of the first Council of Ephesus in 431 AD, convened by Emperor...
  • Why the 21st Century Sucks - Turtles All the Way Down
      A Truly Sucky Century BALTIMORE – What an awful century! Worst we’ve ever seen. Household incomes are down. Employment is down, with 7 million people in the U.S. of working age without jobs. Productivity growth is down. GDP growth is down – to only about 0.5% per capita last year. Even life expectancies are down. Drug overdoses are up. Suicides are up. One out of every eight children lives in a family getting food stamps. One of out every eight adults takes psychoactive drugs...
  • Gold and the Fed's Looming Rate Hike in March
      Long Term Technical Backdrop Constructive After a challenging Q4 in 2016 in the context of rising bond yields and a stronger US dollar, gold seems to be getting its shine back in Q1. The technical picture is beginning to look a little more constructive and the “reflation trade”, spurred on further by expectations of higher infrastructure spending and tax cuts in the US, has thus far also benefited gold. From a technical perspective, there are indications that the low at $1045.40,...
  • The Unstable Empire – A Campfire Tale
      Campfire Tale   Caesar: The Ides of March are come. Soothsayer: Ay, Caesar, but not gone. — Julius Caesar, Shakespeare   GRANADA, NICARAGUA – Today, we stop the horses and circle the wagons. For 19 years, we have been rolling along, exploring, discovering. We began with the assumption that we didn’t “know” anything - so we kept our eyes open. Now we know even less.   Famous people who knew nothing and were not shy to admit it: Sergeant Schultz...
  • Off the Beaten Path in Mesoamerica
      Greeted by Rooster There’s an endearing quality to a steadfast rooster call at the crack of dawn when overheard from a warm country farmhouse.  There’s a reassuring charm that comes with the committed gallinaceous greeting of daybreak that’s particularly suited to a rural ambiance.  The allure of a morning cock-a-doodle-doo somehow falls flat in all other settings.   Good morning everyone! Before meteorological forecasts were available on TV and smart phones, people...
  • Why Silver Went Down – Precious Metals Supply and Demand
      Rumor-Mongering vs. Data The question on the lips of everyone who plans to exchange his metal for dollars—widely thought to be money—is why did silver go down? The price of silver in dollar terms dropped from about 18 bucks to about 17, or about 5 percent.   Reportedly silver was already assassinated in the late 19th century... so last week they must have assassinated its corpse. [PT] Illustration taken from 'Coin's Financial School'   The facile answer is...
  • Systematic Trading - Unwrapping the Onion
      Lumpy but Robust   [ed note: this article has originally appeared at the Evil Speculator and was written by trader and ES contributor Scott. We provide a link to Scott's past articles below this post for readers who want to get more familiar with his ideas and/or any unusual terminology used in this article]   One continual theme in my trading is that every time I think I have it figured out, I get punched in the face by an unexpected problem. The tendency is to go more...

Austrian Theory and Investment

Support Acting Man

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com