Photographer: Tomohiro Ohsumi/Bloomberg

One Sign That Dollar Deleveraging Is Already Here

Money markets turned on their head.

Après nous, le deleveraging?

The rally in the U.S. dollar coupled with seismic changes in the $2.7 trillion money market fund (MMF) industry, is sparking a fresh bout of cross-border deleveraging, according to new analysis from Citigroup Inc. That's because a stronger dollar tends to pressure foreign companies that have borrowed in greenbacks, causing banks to cut down on their international lending as risks in their corporate loan portfolios increase.

Any pullback in cross-border lending would intensify concerns that the dollar rally sparked by Donald Trump's win in the U.S. presidential elections could have a knock-on effect on economic growth around the world.

"Both MMF reform and deleveraging episodes are global growth negative as they are both harmful for the end-users of dollars," warn Citi analysts led by Jabaz Mathai. "The shift in the U.S. from a monetary to a fiscal stimulus is conducive for dollar strengthening which may carry into 2017."

One sign of dollar deleveraging is the changing relationship between Libor-OIS — or the difference between borrowing rates set by central banks and the rate at which banks lend to each other — and the cost of converting local currencies into dollars as measured by the so-called cross-currency basis swap.

Where once the two measures moved in opposite directions, they have now been moving in tandem — a sign that financial institutions' demand for U.S. dollars is potentially waning as "banks de-lever," according to Citi. In such a scenario, banks don't need to issue as much short-term funding in order to obtain dollars, a development that would help push Libor-OIS lower while keeping cross-currency basis swaps relatively expensive.

"We have seen a negative relationship between the two going into the reform but we are seeing a positive relationship between the two in recent months," the analysts wrote.

BICLOISS Index (US Libor OIS Spr 2016-12-05 07-51-04

Steven Zeng, analyst at Deutsche Bank AG, argued in a Dec. 4 note that the breakdown in correlation between Libor-OIS spreads and the cross-currency basis swap might be exacerbated as global markets head into the year-end — a time when banks traditionally cut back on their leverage before presenting annual results to investors and regulators.

"For now, we think the dislocation is in the FX swap/basis market, which in addition to yielding to the usual year-end pressures ... is also seeing increased hedging activities from Japanese investors," who have upped their purchases of foreign bonds in recent weeks, Zeng said.

Still, many see the strains as likely to persist into next year.

"We would like to stress the importance of dollar levels for our investors," Citi analysts concluded. "With Treasury supply likely to dwindle due to the debt ceiling deadline and the possibility of early delivery of a large-scale repatriation, 2017 is gearing up to be a year of squeeze on short-end products."

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