The reason why the Fed must slow down the rise of the USD

Just as families buy on staples, investors and businesses tend to hoard dollars in hard times, pushing prices to a record.

The dollar has blasted higher since the corona-virus crisis in markets intensified, hitting a record high. The US Federal Reserve (Fed) has stepped in by extending to a wider group of other central banks to ensure the stable supply of US dollars worldwide.

Why is the dollar strengthening?

Investors tend to buy dollars during times of geopolitical uncertainty and financial market stress, given that it is viewed as the key global haven. Just as families stock up on staples, investors and companies, as well as banks and hedge funds, are scrambling for dollars to get through the slowdown. This sudden demand has made it more expensive to buy the dollar in the world and in shortage.

Since the beginning of the month, equity markets have plummeted as well as government bond yield. Policymakers have taken steps to address these issues, but at times, equities and bonds have been dropping simultaneously, which a classic sign of market distress.

This prompts companies, for example, to bulk up on dollars to make up for lost revenues.

“People are craving the most secure asset they can find, and that is the dollar,” says Nick Maroutsos, co-head of global bonds at Janus Henderson. “There really isn’t anywhere to hide. People are coming to the realization that you have to be as defensive as possible, meaning you hold cash and some assets when you can.”

Is this a problem?

The dollar is the world’s main reserve and payments currency, meaning it is the currency in which most global trade and investment take place.

The overall size of global liabilities denominated in the U.S. dollar stands at $12 trillion, or 60 percent of U.S. gross domestic product. That means a lot of companies and governments now have dollar debts to pay at a time when revenues are collapsing and economies are grinding to a halt.

The pressure had cropped up in one metric of dollar demand: cross-currency basis swap spreads. Investors were willing to pay towering fees to borrow the U.S dollar, much higher than a few days before.

“Just as no part of the global economy will be insulated from the impact of the virus, no major part of the global economy will be insulated if dollar funding markets break down,” says Brad Setser, an international economist at the Council on Foreign Relations.

Should that happen, Mark McCormick, global head of foreign exchange strategy at TD Securities, says the liquidity problem could turn into a solvency issue. “The U.S. dollar sits at the epicenter of that, and its strength reflects a mismatch of supply and demand for funding,” he said.

What has the Fed done?

The Fed had already set up dollar swap lines with the European Central Bank, Bank of Japan and Bank of England when the coronavirus crisis bit seriously into markets. The move means it can provide dollars directly to local central banks in exchange for local currency, in a bid to increase the availability of dollars in those local markets.

However, this problem has not stopped the rise of the US dollar. Now, the Fed has added nine more countries, including emerging economies to the list of ripping into currencies. They want to prevent funding pressures from evolving into a full-blown crisis.

“These facilities are designed to help lessen strains in global U.S. dollar funding markets, thereby mitigating the effects of these strains on the supply of credit to households and businesses, both domestically and abroad,” the Fed said in a statement.

This problem has happened before. During the 2008 financial crisis, the Fed extended the swap lines to all G10 countries and a handful of emerging market economies, including Brazil or Mexico.

Will it work?

According to Calvin Tse, head of North American forex strategy at Citigroup, the first round of forex swaps had a “large effect” in the countries where the swap lines were deployed. “Barring another shock, the worst of the cross-currency basis widening for those countries may be behind us,” he says.

However, dollar funding costs remain high for others without this access. In addition, these are temporary backstops. For dollar funding pressures to abate altogether, Tse says a sense of normality had to return to financial markets.

“As long as there remain volatility and concerns on growth and health, which then weigh on credit, it will keep feeding on itself,” he says.

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