The U.S. dollar has risen 17 percent against the euro over the past year, as the Federal Reserve has drawn closer to raising interest rates for the first time since 2006.
There could be further appreciation ahead for purely mechanical reasons, given the unique nature of the upcoming tightening cycle and the new tools the Fed will use to raise rates, according to Zoltan Pozsar, a director of U.S. economics at Credit Suisse Securities USA in New York.
To raise short-term interest rates with $2.5 trillion of excess reserves in the banking system, the Fed has designed an overnight reverse repurchase agreement facility that will absorb cash from non-bank counterparties, mostly money market mutual funds.
In an overnight reverse repo, the Fed borrows cash at a specified rate of interest and posts securities as collateral and then unwinds the transaction the following day. Some analysts estimate that this facility could eventually drain more than $1 trillion from the system on a daily basis as the Fed lifts rates.
U.S. money market mutual funds placing that much money at the Fed each day will free up an equivalent amount of short-term dollar-denominated instruments, such as U.S. Treasury bills, for others to invest in—including foreign reserve managers at central banks around the world.
Pozsar, who has been studying the plumbing of the modern financial system for years in positions at the New York Fed and U.S. Treasury, has just suggested in a report that there are already signs of increased interest from foreign reserve managers in dollar assets, especially given that their euros now yield negative rates.
He points to a lesser-known reverse repo facility at the New York Fed—one it operates for foreign accounts.
As of Wednesday, Aug. 26, foreign reserve managers held $163 billion in reverse repos at the New York Fed, up 44 percent from $113 billion at the end of 2014.
The rise is an indication of "reserve managers’ strong demand for safe, short-term, U.S. dollar instruments," Pozsar writes. "But the foreign repo pool is not full allotment. Its size is determined by the New York Fed."
The overnight reverse repo facility the Fed will use to lift rates here at home, on the other hand, will probably be full allotment—meaning the Fed will do as many overnight reverse repos with money funds as the market demands—once the Fed begins raising rates, according to Pozsar.
"A full allotment facility could lead to money funds trading out of U.S. Treasury bills, leaving more for FX reserve managers to invest in," he wrote. "This in turn could unlock flows that are constrained by quantities at present."
The dollar's rise has been a source of apprehension for Fed officials as they try to figure out when to raise rates for the first time in nearly 10 years. The minutes of the policy-setting Federal Open Market Committee's July 28-29 meeting revealed that some participants "discussed the risk that a possible divergence in interest rates in the United States and abroad might lead to further appreciation of the dollar, extending the downward pressure on commodity prices and the weakness in net exports," which have to an extent hindered U.S. inflation and economic growth.
Nevertheless, "most participants still expected that the downward pressure on inflation from the previous declines in energy prices and the effects of past dollar appreciation would prove to be temporary."
The risk is that big flows from foreign central banks rotating out of euros and into dollars over the coming quarters drags out this "temporary" dynamic for a while longer.
Correction: The original version of the chart in this story was labelled "billions" instead of "millions."