This Dollar Shortage Isn’t Likely to Last
There’s a global dollar shortage. On Dec. 15, the cost of obtaining dollars using something called a cross-currency basis swap rose to its highest level since the European debt crisis of 2011.
“There’s never been a worse time to be buying Treasuries if you’re a euro-based investor,” my Bloomberg colleagues Brian Chappatta and Katherine Greifeld wrote last week.
Hang on, though. This should be over within two weeks. The main cause is that big banks are trying to shrink their balance sheets by the end of the annual financial reporting period, Dec. 31. In other words, they want to do less lending, as well as less borrowing. Shrinking their balance sheets can reduce the surcharges that regulators impose on them for bigness—on the theory that size equates to risk.
I asked Zoltan Pozsar, a research analyst at Credit Suisse Group AG, if there was any reason for members of the public to worry about the dollar shortage. His answer was succinct. “No.”
“This is related to a fairly short-term phenomenon,” says Mark Cabana, head of U.S. short-term rates strategy at Bank of America Merrill Lynch. That seems to be the case. As the chart shows, the same thing happened at the ends of 2015 and 2016.
After briefly rising to 0.99 percentage point on Dec. 15, the basis of the 3-month basis swap between the dollar and the euro retreated to 0.56 percentage point on Dec. 20.
A cross-currency basis swap is an interesting derivative. It’s typically used by companies or investors who want dollars but can’t or don’t want to borrow them directly. Instead they borrow in another currency—say, the euro—and enter a swap agreement with someone else who has the dollars they want. A company that borrowed euros would turn them over to its counterparty and get dollars in exchange, agreeing to swap back at some set time in the future, from three months to five years or more.
Theoretically there should be no easy money for either side in a transaction such as this. Moves on the currency side of the deal and the interest-rate side of the deal should precisely offset each other. If you lock in an attractive forward exchange rate when you enter the swap agreement, you will have to put up with a lower interest rate. If this weren’t the case, it would be possible to make a quick profit by exploiting the discrepancy through arbitrage. This is called the theory of covered interest parity, and it “is the closest thing to a physical law in international finance,” according to an article last year in the Bank for International Settlements’ Quarterly Review.
But as the Quarterly Review authors acknowledged, the iron law of the no-arbitrage condition is routinely flouted. The chart makes that clear. The “basis” in the chart represents the discrepancy between the cost of borrowing dollars directly vs. obtaining them through the foreign-exchange market. The basis would always be zero if the law worked perfectly. Clearly it doesn’t. A big reason is that the banks, which could profit by providing dollars on advantageous terms, don’t want to take on any new transactions at year’s end.
One strong indication that the dollar squeeze is nothing to worry about, says Bank of America’s Cabana, is that other parts of the financial markets are showing no signs of stress. The Chicago Board Options Exchange Volatility Index, or VIX, which is often called the fear index, spiked wildly the last two times there was a big move in cross-currency basis swaps, i.e. in 2008 and 2011. This year the VIX is trending near record lows.