Is There a US$ Shortage? Will it Sink the Global Economy? Again?
Reader Patricia is wondering about a recent ZeroHedge article, The Global Dollar Funding Shortage Is Back With A Vengeance And "This Time It's Different".
The last time the world was sliding into a US dollar shortage as rapidly as it is right now, was following the collapse of Lehman Brothers in 2008. The response by the Fed: the issuance of an unprecedented amount of FX liquidity lines in the form of swaps to foreign Central Banks. The "swapped" amount went from practically zero to a peak of $582 billion on December 10, 2008.
The USD shortage back, and the Fed's subsequent response, was the topic of one of our most read articles of mid-2009, "How The Federal Reserve Bailed Out The World."
As we discussed back then, this systemic dollar shortage was primarily the result of imbalanced FX funding at the global commercial banks, arising from first Japanese, and then European banks' abuse of a USD-denominated asset-liability mismatch, in which the dollar being the funding currency of choice, resulted in a massive matched synthetic "Dollar short" on the books of commercial bank desks around the globe: a shortage which in the aftermath of the Lehman failure manifested itself in what was the largest global USD margin call in history....
Another Margin Call?
Reader Patricia writes...
I have believed for quite some time that the catalyst for the 2008 crash was the action of European Commercial banks. They got themselves into huge trouble by creating a huge mismatch in their asset and loan funding requirements. That led to a global US dollar shortage which the Fed mitigated using their special swap facility. So the Fed bailed out the rest of the would at the expense of US citizens.
So now it appears this problem is happening again. Will the Fed attempt to bail out the world once again? Zerohedge seems to think so, but they are sometimes on the wrong side of the inflation/deflation argument.
I know you are busy and may have more important things to write about, but maybe you could keep this issue on the back burner.
Result or Cause?
Here was my answer to Patricia ...
"I do not believe there is a dollar shortage or even a synthetic dollar shortage. More importantly, a dollar shortage certainly did not cause the crash in 2008. Excess debt and speculation caused the crisis in 2008. Any alleged or apparent dollar shortage was a result, not a cause of the crash."
Acting Man Chimes In
I replied to Patricia and copied Pater Tenebrarum at the Acting Man blog. He replied in much more detail than I did.
I agree with Mish that the currency effects are a consequence, not a cause of crisis conditions. There are large amounts of dollars held in deposits abroad, and fractional reserve banks are of course lending them out. It is true that they routinely have sizable asset/liability maturity mismatches, but this is true of all banks everywhere, regardless of the currencies employed.
An additional difficulty is created by the fact that prior to the swap arrangements, overseas based 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 fled (US money market funds are a major source of these dollar deposits, and they pulled back when the US mortgage credit bubble blew up).
However, this concern is by now academic, since the swap lines now do exist, and are unlimited. Note that the US taxpayer has not suffered any harm, as all the swaps have been paid back (and even if they hadn't been: no-one was actually "taxed" to pay for them. The money was created from thin air, with the push of a button).
The real problem is that the current monetary system hurts everyone, not only due to constant debasement of currencies (falsely labeled "price stability"), but due to its ability to expand credit and create additional money substitutes with nary a limit, which distorts relative prices in the economy and leads to malinvestment of plenty of scarce capital (the housing bubble was a prime example of such malinvestment, and the same applies to the fracking boom).
Impoverishment is the result, although there are of course groups in society benefiting from these policies (otherwise there would be no reason to pursue them). There is however not only a redistribution of wealth associated with credit and money supply expansion, but a loss of real wealth for society at large.
To come back to the funding of dollar assets, currently we see euro basis swaps trading in negative territory again, which is indeed an indication that dollar funding conditions have tightened. There are approximately $9 trillion in dollar-denominated debt outstanding abroad, a not inconsiderable amount. It is also true that this basis swap "penalty" rate is an indication that there is a measure of distrust in the system: dollar lenders are recompensed for taking credit risk.
Per experience, European banks will accept a pretty big negative basis before applying for funds from the swap window, since those funds don't come for free either.
However, it is actually not correct to speak of a "dollar shortage". The domestic dollar money supply has more than doubled since 2008, and a large additional amount of dollar creation has "escaped" into accounts held abroad. (The dollar money supply outside of the US has also increased greatly).
It is not a shortage of dollars, but a growing unwillingness of dollar holders to lend them out that creates a problem for banks in need of dollar funding.
Demand for Dollars
It's amusing to discuss currency shortages given all the central banks are or have been flooding the markets with currency in an inane attempt to cure a debt problem by forcing more debt into the system.
I discussed this on Monday in Draghi's Goal: Higher inflation and Negative Yields; ECB's Asset Purchases to Outstrip Supply 3-1; Is There a Catch?
That interest rates are negative in Germany for every duration from one month through six years (only two basis points from seven) speaks for itself. There is no demand for loans relative to supply of euros from the ECB.
All Draghi has done is shove more risk down the throats of various national central banks. The result is banks in Spain are stuffed with Spanish bonds; Banks in Germany are stuffed with German bonds; Banks in Portugal are stuffed with Portuguese bonds.
The ECB is taking on 20% of this risk of Draghi's 1.1 trillion bond buying spree. Countries have 80% of the risk. Bond traders front-ran the trade. They are all betting on increasingly negative yields. No one wants credit. Why is that?
Reasons for Lack of Lending
- There is too much debt in the system
- Creditworthy businesses do not want to expand in a deflationary world
- Banks rightfully do not want to lend to credit-unworthy customers
- Banks are still capital impaired in spite of what stress tests say
- You cannot fix a debt problem with more debt
There are no other possible reasons that would explain the setup we are in. It is not a matter of confidence as Draghi believes.
Given that Bernanke and Yellen somehow managed to pass the QE baton to Japan and the ECB, it is entirely possible the US dollar soars to unimaginable heights. Some might think we are already there.
At some point however, this will reverse. And it may not take much to do it.
Let's step back one more time with a simple question. Why is there an overwhelming belief in dollars?
Three Reason for Belief in Dollars
- Most believe the Fed will hike
- The US stock market is rising
- US interest rates are higher than Europe and Japan
Point number one is quite suspect. Yes, the Fed may very well get in a hike or two (or not). But if the Fed does not hike as much as expected, demand for dollars will likely sink quite rapidly.
Also consider point number two. Not only is the US dollar rising, so are US stocks. This creates a huge demand for dollars and various carry trades.
Right now, US stocks are a one-way and massively one-sided trade.
Point number three is likely to stay that way. But, it is relative moves and directions of moves that matter. In effect, if point number one disappoints, so will point number three.
Same as 2008 or Opposite?
The US dollar index is at roughly the same level as in 1998, also 1988 (not shown). The peak in 1985 was 164.72. The peak in 2001 was 121.21.
On September 15, 2008, Lehman filed for bankruptcy. The dollar bottom was in April of 2008, at 71.33.
At that time, anti-US$ sentiment was massively in vogue.
The Schiff's of the world were screaming hyperinflation. Today, US hyperinflationists are thoroughly discredited and in hiding.
Today, nearly everyone loves dollars and hates gold. Dollar swaps that were not in place then, are in place now. All things considered, conditions are nearly the opposite of 2008.
Swaps vs. Alphabet Soup
The Fed did not save the world with swaps.
Historian will surely debate Bernanke's policy moves for the next century. Bernanke did initiate a huge number of lending programs (cleverly dubbed "Alphabet Soup" by Bloomberg columnist Caroline Baum).
Those lending programs eventually revived the corporate bond market in 2009. One of the programs was dollar swaps. It's debatable if that was the key program.
If one wants to ignore all Bernanke's mistakes that led to the crisis, and give him credit for "Alphabet Soup", so be it. In fact that will be the nature of the future historical debate, and I doubt history will be so kind.
Expect New Script
The next crisis is highly unlikely to follow the 2008 script, because the 2008 script is what central banks have prepared for.
Bernanke, followed by Yellen, then the Bank of Japan and then the ECB have all carried competitive QE madness so far that a currency crisis is now baked in the cake. No one see its because it will not be "obvious" until long after it happens, just as with the dot-com bust and the housing bubble.
Central banks always strive to prevent the last crisis. In doing so, they plant the seeds for the next crisis. Unwarranted and counterproductive global QE is highly likely the seed for the next crisis.