October 3, 2017 / 10:44 AM / 9 months ago

Commentary: Rising dollar exposes pockets of funding turbulence

LONDON (Reuters) - The dollar has just chalked up its biggest weekly rise of the year, and esoteric corners of financial markets are feeling the squeeze.

United States one dollar bills are seen on a light table at the Bureau of Engraving and Printing in Washington November 14, 2014. REUTERS/Gary Cameron/File Photo

Euro ‘cross currency basis’, which measures the cost to companies and financial institutions of swapping euros into U.S. dollars without the exchange rate risk, has mirrored the move and is now at its widest level since January.

This points to pockets of turbulence suddenly appearing in dollar funding markets and the difficulty some non-U.S. banks and firms are having in accessing dollars, at least in the near term.

Anecdotal evidence suggests there has been an increase recently in euro-denominated borrowing from the emerging markets, where non-bank dollar debts are approaching $11 trillion, according to the Bank for International Settlements.

A rise in the dollar and U.S. yields makes servicing that dollar-denominated debt more costly, fuelling demand to borrow in euros. These euros are then swapped back into dollars, which widens the cross currency basis.

The squeeze comes just as Fed chief Janet Yellen has stoked expectations that U.S. interest rates will be raised again by the end of the year, sending the dollar and U.S. yields sharply higher. Fed funds futures now point to a near-80 percent probability of a rate hike in December.

Two- and 10-year Treasury yields jumped 15 and 20 basis points, respectively, in September, their biggest monthly increases of the year. The dollar rose 1 percent last week, its best week of the year.

This follows similar bouts of widening in the euro/dollar cross currency basis over the last couple of years: in November 2015 (ahead of the landmark first post-crisis U.S. rate hike); mid-2016 (as the two-year dollar rally reached its peak); September 2016 (jitters over the health of Deutsche Bank); and December last year (Fed rate hike and year-end demand).

Seasonal effects are at play too. Funding pressures often bubble up at quarter- and year-end as banks look to secure a supply of dollars to spruce up their balance sheets.

All this has pushed out the three-month euro basis to 47 basis points, the highest premium to swap euros into dollars since January. Last week’s surge of 10 basis points was the biggest weekly move this year, and one of the biggest since the white heat of the euro crisis in late 2011.

Back then, the widening in the basis was far more dramatic, to more than 150 basis points, reflecting extreme systemic risk as the very existence of the euro zone was under threat. Similarly, when the global financial system was close to implosion in 2008, the three-month euro basis blew out to more than 300 basis points.

In benign market conditions ‘cross currency basis’ should show virtually no premium at all for one currency over another. But the premium for dollars has widened sporadically over the last few years.

This is due to banks having to cover currency mismatches between assets and liabilities on their balance sheets, investor hedging, patterns in corporate bond issuance, and differences in the big central banks’ policy stances.

The European Central Bank’s negative interest rates and aggressive QE, as the Fed is slowly begun tightening policy, has made it more attractive for U.S. firms to issue debt in euros and swap back into dollars via the cross currency basis market.

As the basis widens, like now, it should eventually become more attractive for European firms to bypass the cross currency market and issue debt in dollars directly. Ultimately, the system should self-correct, although at what level is difficult to pinpoint.

While the euro basis is now its widest since January, it has been wider in the last two years, reaching 80 basis points in December last year. So it may have room to widen further.



 The opinions expressed here are those of the author, a columnist for Reuters.

Reporting by Jamie McGeever; Editing by Catherine Evans

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