Last week, the Bank of England, European Central Bank, Bank of Japan and Swiss National Bank, amongst others, in conjunction with the Federal Reserve, announced their intention to reduce the usage of USD swap lines. These ‘liquidity operations’ have become commonplace in times of crisis – they were particularly prevalent during 2008/09 and were reintroduced in March this year to combat funding tensions that resulted from the COVID driven market turmoil.

Unsurprisingly, the news of their withdrawal came and went in a flash and wasn’t a big discussion point in the mainstream media. In part, this was almost certainly due to a lack of understanding on the topic (I admit, I had to do some research to better understand what it meant!) but also because those who are in the know, appreciate the demand for dollar funding has reduced significantly since May and consequently, so has volatility in the financial markets. The fact that the Central Banks feel able to step back is testimony to the significant improvement in market conditions.   

So, what does this mean for the FX market going forward? There are three key areas for us to focus on:

  • Hedging Costs – Back in June, we discussed this topic in-depth (link) and highlighted the implications of a blow out in cross-currency basis. The spike in demand for dollar funding resulted in an additional pick-up for USD denominated vehicles hedging EUR and GBP assets. In contrast, it was an additional cost (on top of the interest rate differential) for EUR funds hedging USD exposures. However, central bank intervention quickly reversed this and briefly had the opposite effect (see chart below). Today, EURUSD 3m basis is almost flat (meaning the sole influence on forward points is the interest rate differential).

Chart 1: EURUSD 3m Cross Currency Basis

Source: Bloomberg
  • Spot Rates – Although the direct implications of the Fed’s swap lines should net to zero, indirectly, the inverse correlation between the dollar and risk appetite has been well publicised. We’ve long become accustomed to the notion that the dollar strengthens when markets are in ‘risk off’ mode (due to its reserve currency / safe haven appeal) but then weakens during times of ‘risk on’. Therefore, its no surprise to see that the dollar has been under pressure in recent months at a time when usage of the Fed’s swap lines has drastically fallen (implying that markets are working normally and efficiently). This is shown in the chart below. EURUSD (orange line) started to rally shortly after the Fed’s swap lines were reduced at the beginning of June, and has continued to advance as demand for the Fed’s liquidity operations has fallen.
 Source: NY Fed & Bloomberg
  • Potential Risks – Both the Fed and the ECB have said that they stand ready to readjust the provision of USD liquidity if market conditions warrant it. This should help to keep markets calm and maintain confidence in the financial system if concerns surrounding a second wave or another external shock were to unfold. That said, there is always a risk of delay between market dislocation and central bank intervention which could trigger short term volatility in the USD that we should remain wary of.

USD Outlook

While it is reassuring for markets that the major Central Banks stand ready to provide liquidity during times of market stress, that may not be enough to prevent those stresses from arising in the first place. Either way, if the Central Banks are forced to intervene, the likelihood is that markets would already be in ‘risk off’ mode and hence the dollar would be in demand in the spot market, even if forward markets are kept at equilibrium. Meanwhile, we continue to believe that factors like positioning, carry and the ‘overbought’ nature of certain currencies (especially the euro) against the dollar makes a correction in the recent dollar decline increasingly likely.

Author: Marc Cogliatti