Dollar Illiquidity Getting Critical: A $10 Trillion Short Which The Fed Does Not Understand

In the latest report from ADM ISI’s strategy team, “Dollar Liquidity Threat is Getting Critical and Fed is M.I.A.”, Paul Mylchreest argues that mainstream economic luminaries (like Carmen Reinhart) are finally acknowledging the evolving crisis due to the dollar shortage outside the US, a topic which even the head researcher at the BIS shone a spotlight on yesterday suggesting that the strength of the dollar, not the VIX is the new “fear indicator”. 

The bitter irony is that the institution which appears to have very little understanding of what’s actually happening is the Federal Reserve. We noted Stanley Fischer’s speech yesterday when he argued that liquidity is “adequate”…. at least he didn’t say “contained.”

Yet Dollar illiquidity has been one thing that central banks can’t control…think SNB and Swiss Franc, BoJ and Yen (full report on this below) and now the PBoC as the RMB looks at 6.90. Mylchreest points out that Fischer could take a look at dollar cross currency basis swaps (chart below) and the dollar liquidity problem would be immediately obvious. 

Fischer could take a look at dollar cross currency basis swaps (chart below) and the dollar liquidity problem would be immediately obvious.

While everybody is now waiting for the Fed to wake up, here at ZH we have been tracking the issue of a global dollar shortage well ahead of the mainstream, starting back in 2009 and continuing with “The Global Dollar Funding Shortage Is Back With A Vengeance And ‘This Time It’s Different” in March 2015 and “Global Dollar Shortage Intensifies To Worst Level Since 2012” in October 2015.

If the dollar continues to strengthen, it will spell trouble for the recently adopted market narrative that Trump brings higher inflation and higher rates. Another major rotation and market reversals are the last thing that active managers need, or can can afford, in the run up to year end.

From the first section of the report:

We know the narrative…Trump equals higher inflation, a tailwind for commodities and a headwind for bonds. We are “Endgame Inflationistas”, but declining US dollar liquidity threatens this narrative near-term.

Dollar illiquidity is something that even central banks struggle to control, e.g. Swiss Franc peg, BoJ losing control of the Yen and now the PBoC/RMB.

The price of the dollar acts like a “Global Fed Funds Rate”. A rising dollar tightens economic conditions globally, adding considerable deflationary pressure as is clear from the chart below.

Most commentators are not making the link between a rising dollar and a shortage of offshore dollars (Eurodollars). China’s financial system is vulnerable and it’s being reflected in RMB weakness.

The lack of a dollar swap between the Fed/PBoC is a glaring omission. We expect BRICS nations to become increasingly irritated about the current dollar-based system.

In his recent speech, “Is There a Liquidity Problem Post-Crisis?”, Fed Vice Chairman, Stanley Fischer, concluded that liquidity is adequate. Sadly, that is incorrect and a glance at the chart (below) of negative Cross Currency Basis Swaps for dollar funding illustrates the error all too easily. A US$10 trillion Eurodollar short is a more dangerous and risky beast if the Fed doesn’t understand it!

The table below shows the Cross Currency Basis Swap (CCBS) for US dollars using the average for Euros, Yen, British Pounds, Swiss Francs and Canadian Dollars. We discuss the CCBS in more detail below but, in essence, it is the additional cost of borrowing dollars via FX swaps in these currencies compared with what it should be according to interest rate differentials. The more negative the CCBS the more it implies a structural dollar shortage and a liquidity problem in dollar funding markets.

While the problem has been building for more than 2 years, mainstream economic luminaries are (belatedly) starting to take notice. This was Harvard’s Carmen Reinhart last month.

“Today, seven decades later, despite the broad global trend toward more flexibility in exchange-rate policy and freer movement of capital across national borders, a ‘dollar shortage’ has reemerged.”

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Much more in the full report below.