New Fed Paper on Crisis and the Dollar--Interesting

The October issue of the NY Fed's monthly Current Issue was just released. There is an article that may prove interesting to further understand how the crisis impacted the dollar. It can be found here.

It is written by Niall Coffey, the chief dealer for foreign exchange and a financial specialist in the NY Fed's Markets Group, Hoai-Luu Nguyen, an economist at the NY Fed, and Asani Sarkar, a research officer there.

The essay is mostly devoted to understanding what happened to the dollar basis in the swaps market (the difference between the spot and forward exchange rates of two currencies, which is usually the interest rate differential). Prior to the crisis the dollar basis hovered near zero. This means that the cost of dollar funding was essentially the same for most participants regardless of size or location. The basis exploded and at the worst was near 250 bp. However, while this discussion is interesting, the context may be even more noteworthy.

The conventional narrative is that as the crisis became more acute the demand for dollars was a function of safe haven demand. This Fed report instead offers a somewhat different explanation and one that we have long suggested ourselves. Namely that the demand for dollars was short-covering rally as the greenback had been used as a funding currency.

The Fed's largely assumes this in its explanation of the basis movement. In particular, the essay recognizes that international firms need dollars to fund their investments in dollar-denominated assets. During normal times, these firms secure their funding via unsecured cash market, commercial paper and fx swaps. The essay cites BIS research which showed that European banks in particular had increased their dollar assets from $2 trillion in 1999 to more than $8 trillion by mid-2007. These non-US institutions without a natural dollar base needed dollars to support their off-balance sheet conduits.

Separate from the NY Fed paper, we also recognize that many leveraged investors also borrowed dollars to fund purchases of emerging markets and commodities. We also note that investors in a number of emerging market countries, from Brazil and Mexico, to South Korea and Russia borrowed dollars to often lend at significantly higher rates to their own governments.

Since the middle of Q2 we have been arguing that the dollar is again being used as a financing currency. It is difficult to see the dollar sustaining a rally as long as the incentives to do so remain intact. Those incentives are two-fold. One is the interest rate differential. The other is the general appetite for risk.