Fed Swap Lines, USD Shortage and a Policy Transmission Problem

Today the Fed made an excellent decision in expanding the list of CBs eligible to USD swap lines.  The point of this note is to try and clearly explain the issues in the current dollar shortage and why swap lines by themselves may need to be expanded in terms of definition because the actors are not the same they were in 2008. The USD funding market is 13t dollars according the BIS and it is under huge strain. Today's announcement of the Fed adding nine more CBs to the central bank swap line program is huge and will hopefully alleviate some of the issues below. As a side all the credit for this post goes to Brad Setser and Hyun Song Shin as they set the standard on these dollar issues and how they impact the real economy.

USD is the dominant global macroeconomic variable

To me, the dollar is the dominant macroeconomic variable. In terms of the financial and real economy, the dollar sets the pace. Right now there is this fascinating duality going on where the world in a binary sense is either extremely long USDs via lopsided international investment positions or extremely short them via credit intensive supply chains. The problem is, the world is not binary, it is incredibly nuanced. And what is making it worse is all these things cracked at once. And under the current reaction, the Fed seems to be reacting to old USD world not the one we live in now.

What has the dollar been saying in its reaction to covid19, and what stage are we in:

First reaction (end of February): USD is a risk currency via a massive negative NIIP positioned. As that flow into assets has roared, more and more of it was unhedged. This contributed to an imperial circle of sort which I have discussed in past posts. So what happened, risk markets started to get hit, new flow into US assets stopped and the dollar got sold.

Second reaction (early March): As the pandemic rolled on, supply chains, which were already stretched and vulnerable, began to break. What do we know about supply chains, they are incredibly credit intensive, especially the longer ones. The other thing we know about them, many of them fund in dollars. As they break, they hoard USD for payment and FX basis blows out and CIP deviation furthers. Which is when the Fed comes in with central bank swap lines.

Third reaction (where are now): Supply chains are breaking, Fed swap lines are not frequent enough in an operational sense and they don't reach far enough in terms of jurisdiction. The dollar shortage is becoming more amplified because key economies are left in the cold. The RBI did two yards of USDINR swaps, and 4b was on the bid. Global corps, especially ones that are part of long supply chains, are stretched and desperate for dollars. To make matters worse, there is a transmission problem in terms the Fed's swap lines. Outside of Japanese financial institutions, most of these players are non bank actors who need USD. This is another example of the Fed's liquidity transmission being broken, the problem is, the 13t dollar funding market is in trouble and it is mostly non banks which makes it harder to get them the support needed.

Before we go into the background, here is the conclusion: The Fed has more to do in terms of FX swap lines. There is a combination of supply chain weakness in EMEs and a misdiagnosis of the problem in terms of who actually uses the FX swap market. Since the crisis, it is mostly non banks hedging UST and US credit exposure. The Fed needs to go to the root of the dollar issue, and unlike 2008, it is no longer getting swap lines to the ECB to fix dollar mismatches in the European banking sector. Asian lifers and pension funds are now the massive players and they need much more directional help.

Two key actors and 13t dollar funding market.

1) Credit intensive supply chains

2) Non bank actors who are biggest players in FX swap market to hedge US credit risk

The point is, until today, the Fed was in no mans land re these CB swap lines. The supply chain pinch is in EM and the financials that use the FX swap market are no longer banks playing US mortgages, its non bank actors like Asian lifers and pensions that FX hedge US credit. Neither are getting the help they need. The transmission of these swap lines needs to be adjusted to further ensure effective policy transmission.

Part 1 of the Fed's problem, the 13t USD funding market 

There is an implicit loanable funds framework to this which may not make this so popular, but the basics of it is, USD cross border flows = RoW USD lending to global actors.

The problem global actors have is, this 13t dollar funding market is very fickle and as supply chains have become elongated, they have become more and more credit intensive. This sets up a two part problem for supply chains.

1) The level of the dollar effectively determines how much financing they can do. And as the BIS has explained, this sets off a bit of a doom loop. When there is a credit crunch for these actors because the shadow price of credit is rising, output falls off, which only strengthens the dollar (less economic beta to exports than RoW), and this fire can only be put out by the Fed.


2) When the dollar goes up, financial conditions freeze which only amplifies their need for USD. An example of how bad it is was in India this week. RBI did a 2yard auction in which there was over 4b on the bid. Korea is another example, BoK did a large intervention last night selling USD v KRW and spot rate still went up 2%, only to be arrested by the Fed announcing a swap line to them this morning. These guys are outmatched without Fed/IMF help.




BIS has done amazing work explaining what are the key parts of the 13t USD funding market.

1) The broad dollar effectively shows us dollar funding conditions in the global economy.

2) As Hyun Song Shin has explained, it is also an indicator of bank balance sheet capacity via VaR. Assume the counterfactual to make this point more clear.

"If a global has a diversified portfolio of loans to borrowers around the world, a broad-based depreciation of the dollar results in lower tail risk in the bank credit portfolio and a relaxation of the banks VaR constrain. The result is an expansion in the supply of the dollar credit, through increased leverage."

The point is: if a weakening dollar can expand bank capacity to lend, a stronger dollar does the inverse of that and tightens capacity.

These two things are what connect the level of the dollar to the real economy. As I've said in prior posts, the dollar is a culprit and a reflection about the level of global GDP. On the hand it can impose weakness via shadow credit, and at the same time it can reflect the weakness in global trade and supply chains via a lower beta to global growth. This is the result of a currency that is 50% of global trade invoicing and is only 18% of global GDP. This mismatch between USD representation in terms of US contribution to global GDP and its global usage is only further evidence of how important the Fed is outside of their domestic mandate when the world is in crisis.

Part 2, the non bank financial actors that run the FX swap market

Something I have gone into over the past few weeks, is that Asian demand for USD assets has been relentless since the crisis. So big that it has ballooned into $8t international investment position for Asia. The reason has been relatively simple, it is capacity. Asian real money assets are over 10x the size of their domestic IG market with the Japan the extreme at over 20x. Add on the fact that it was positive carry, and the money flew into finance US deficits, especially in the private sector.

In a prior post I focused on the unhedged aspect of this trade, especially as it relates to Taiwanese life insurance companies. And while that is still an issue, when liquidity dries up the issue expands to the hedged aspect, especially as these guys hedge in the front end to own longer term USD assets.

So what happens when there is a crisis, over 11% of demand for US credit goes quiet (outside of stealth GPIF interventions). And this amplifies the liquidity crisis onshore. The problem is, swap lines go to banks, and the biggest players this time around are non bank actors. And these non bank actors are so big that when they have issues, it is felt in illiquidity onshore. For many of these guys, liquidity in the global money markets = capital market liquidity onshore in the US! So the Fed needs to get liquidity to these guys in order to help restore second and third order liquidity.

This is the importance of transmission. Dollar auctions are nice, but the non bank actors need access to them. If the Fed can arrest pressure here, that will be job done and the positive ramifications will spillover into things they definitely care about, like liquidity in US credit and treasury market.

This is why the FX basis market and the broad dollar index have shown such a strong correlation.




What will the Fed final reaction be, what are the key characteristics of this USD shortage?

I can't underestimate how big today's move is and I applaud the Fed for doing it, it is very necessary. My only fear now is, is not only that this list of 16 CBs is still not long enough, but that the transmission is much more complicated this time around, as supply chains are much more in EMs and the biggest player in FX swap market these days are not banks, its non bank players.

So what are the key characteristics of this shortage

- Within foreign banks, its not homogenous among who funds in USD. Canada and Japan, are not in the same boat as Europe for example.

- The biggest players in the FX swap market are not banks anymore, its non bank actors who use it to hedge longer duration USD exposure.

- Supply chains are breaking and they are more often situated across EM's and EM CBs are being overwhelmed by local demand and massive portfolio outflow. Also EM CBs this time have decided it is better for FX to fall apart than to hike rates.

- Real yields are spiking as they are everywhere

- Oil is making it worse, petro dollar players are in trouble as oil players are all in USD.

Conclusion: The Fed has two key things to do after today's necessary decision. 

1) Make sure transmission of swap lines is working, it is harder in this crisis because banks are not the main problem. Non bank actors are that big now, and they can exert pain in liquidity terms in far reaching ways, which is effectively what we've seen.

2) EM's need help now. The Fed and the IMF need go past the 16 CBs currently on USD swap lines. This problem is only amplified as EMs are not hiking rates this time around as they are letting exchange rates be the punching bag.

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The Gravitational Pull of the Lower Bound

The idea of this is not to say the world is ending, or that this is an economic forecast in any way. The point of this note is to offer a different perspective on what is currently weighing on the bond market as the broader context of these under-appreciated technicals seems very important. Also, if these factors are right, and continue to push yields lower, it will end up being very supportive for asset prices, especially in the US.

We are at a critical stage in monetary policy in the US. Three key themes. 

1) When r* is this low, there is an innate bimodal distribution for the funds rate, you are either close to neutral or close to 0. And this is the exact setup the market is facing now, does 50 do the job or does 0 beckon. Did the Fed adjust to a shifting goal post in terms of neutral, or is this part of a "natural" move to 0. We will soon find out and it should create real two way action in Eurodollars going forward.

2) There is considerable research to suggest the ZLB is binding a significant percentage of the time when r* is low. Ben Bernanke has made this point multiple times over the past year, most recently in his keynote speech at the AEA conference in January. Bernanke's point was, assuming r* in the US of 1%, there are Lower for Longer (L4L) policies the Fed can do to add policy space and minimize ZLB episodes. His forecasts show that under a traditional Taylor rule with 2% inflation target and r* of 1%, the lower bound is binding 30% of the time. Even assuming L4L policies, that number is still around 20%. The point is, ZLB episodes are extremely difficult to avoid when r* is this low, that's just the nature of the beast.

3) The other source of this gravitational pull towards 0 is, divergent interest rate levels are innately unsustainable. The Fed wants to react domestic factors in line with their dual mandate of price stability and maximum employment. However, too much of the policy setting is set abroad. As we learned in Jackson Hole this year from the terrific Riders on a Storm paper, around 50% of the of the monetary policy stance comes from global factors. This goes a long way in explaining that despite 50 year lows in unemployment and inflation not far from target, the Fed has now cut 125bps in less than a year.

Conclusion: 

The market and FOMC are entering a critical phase which seems bimodal in an outcome sense. Either, the Fed was able to instill enough accommodation to reduce ZLB risks, as their research suggests, when close to 0 act swiftly, or, the natural forces of this very low r* world are exerting their natural forces and bringing down the funds rate to its lower bound. Said another way, will the Fed be able to adjust for lower r* and tighter financial conditions, as they did in 2019 in response to tariffs. Or, have we reached the point of no return in terms of the immense pull of a binding lower bound.

The Fed is in no mans land between neutral and 0, the power of the zero lower bound pull

One of the things that is most interesting at the moment is the sheer speed at which the market priced Fed rate cuts. There is a cascading feeling to US bond yields at the moment and the reason is deeper than just uncertainty about the current shock.

The problem the Fed has, and why the market has gone so fast in pricing implieds, the Fed is is no mans land. As we have seen in research from places like DE Shaw, when r* is low, there is an innate bimodal distribution to the funds rate.

The sum of it is, you are close to neutral or at zero.

As the shock has evolved the, market has transitioned from pricing natural negative permia of an asymmetric reaction function, to the pressing need for rate cuts to arrest the decline in financial conditions. As the market prices a lower policy rate, the gravity of the lower bound begins to kick in and this vicious rally in bonds begins.

One of the reasons the Fed was relatively aggressive last year in lowering the policy rate was because of the well known research that when you are close to the lower bound, you have to be aggressive to minimize the chances of hitting it. This is why the research topic du jour in the Fed framework review has been about creating policy space in a low r* world. The problem now is, this shock is different than tariffs via the exchange rate channel (limiting USD upside), and the Fed has already played the insurance card. The gravity of the ZLB is, 125bps in rate cuts over the course of the year is no longer insurance. I.e. part of the reason this move in rates has been so swift is, the market has to consider that the "adjustment" period is over and zero beckons. The idea that Fed can continue to recalibrate policy relative to their celestial stars is getting exhausted. That doesn't mean they cant cut 100bps and say job done, but the real message of this move in market pricing is, the Fed is caught in no mans land and "gravity" or the binding ZLB will continue to pull them to zero in the case of shocks.

This chart is Bernanke's estimates for ZLB frequency under a traditional Taylor rule model and 2% inflation target. As we know from his work with Kiley and Roberts last year, that under assumption that r* = 1, the ZLB is binding around 30% of the time. Even with some lower for longer (L4L) policies like QE and forward guidance, the ZLB is still binding around 20% of the time. The point is, especially under more traditional monetary policy settings, it doesn't take much to push the Fed back to zero.




So what do we know so far, 2 things:

1) When r* is low, the bindingness of the ZLB bites and is like gravity pulling interest rates to zero

2) When r* is low, there is innate bimodal distribution, you are either at neutral or zero

Now, this is pretty powerful on its own, but what if r* is even lower. Both the DE Shaw chart and much of Bernanke/Kily/Roberts, have base assumption that r* is 1. What if its 0....

One of the biggest differences between 0 and 1 in terms of the level of real neutral rates is, there is more room for L4L policies to contribute at r*=1 in terms of adding policy space and limiting chances of ZLB episodes. Bernanke said, if the nominal neutral interest rate is between 2-3%, which is what is assumed for the US economy, then L4L (lower for longer) policies can add up to 3% of policy space at the lower bound.

However, "if the nominal neutral interest rate is much lower than 2 percent, then the model simulations imply that the new monetary tools—while still providing valuable policy space—can no longer fully compensate for the effects of the lower bound."

So now we have to add a third finding, if the r* is actually closer to 0 than 1, than the Fed even by adopting lower for longer policies, which they will for sure try and do with their strategic review, will still very much struggle in preventing ZLB episodes.

Another factor in pricing the funds rate, so much of r* comes from abroad

One of the more interesting macro themes of the past few year, which continues to prove itself, is that divergence, especially in monetary policy is unsustainable. There have been two key papers from the academic side that encapsulate this message.

1) Something Kristin Forbes has been talking about since Sintra 2018, there is a global Phillips Curve and that has a massive impact on the slope of any local curve. In her latest paper, a couple months ago, "Inflation Dynamics; Dead, Dormant or Determined Abroad?" Dr. Forbes posits that domestic CPI inflation is increasingly determined abroad.

One of the charts from her paper show, that incorporating "global variables" such as commodity prices, world slack, exchange rates, and global value chains, are necessary in forecasting domestic inflation.

"This chart shows the resulting “error” between actual inflation and inflation explained using the rolling estimates. It shows the superior performance of the model with the global variables (in red) relative to that with only the domestic variables (in grey) and with the domestic variables plus import prices (dashed black)."

If global factors lead to reduced model error in expected inflation outcomes, then obviously global variables are having a large impact on domestic prices.

2) Arguably the star paper from Jackson Hole this year, "Riders on a Storm", shows that interest rates are increasingly correlated to moves other than Central Bank reaction functions and domestic mandates.

"Taken together, the average monetary policy stance explains only about half of the variation in interest rates. The other half of the time, interest rates move for reasons other than a central banks response to the economic outlook."

Variance decomposition of real short term interest rates (calculations by Jorda and Taylor)

The point is, inflation and neutral interest rates are increasingly a globalized concept, monetary policy does not exist in a vacuum. Another example of this, from their paper is how synchronized policy rates have become.

Stance of monetary policy is highly synchronized (calculations by Jorda and Taylor)

Global factors are pushing the Fed, despite the FOMC being the closest CB to its mandate.

So to update again, now we have 4 strong factors anchoring front end yields lower

1) When r* is low, the bindingness of the ZLB bites and is like gravity pulling interest rates to zero.

2) When r* is low, there is innate bimodal distribution, you are either at neutral or zero.

3) If r* is below 1%, the ability for the Fed to minimize ZLB episodes is further curtailed.

4) Low r* has large global beta, from the nominal neutral level of interest to inflationary forces.

If the Fed ends up at 0, what comes next, steepeners never work but they may have to this time

A good place to look at how the Fed will likely respond in the case of conventional policy space running out, is Governor Brainard.

One of the reasons steepeners have been a brutal trade since the middle of last year is, despite their approach of preemptive policy, the Fed has not really been cutting to get ahead, they have been cutting relative to shifting goal posts. This is why the dollar has remained strong and the curve flat.

However, this time really could be different, especially with 10y note yields sub 1%. If the market is seriously going to entertain the lower bound, then we know two things.

First, it will stay there a while. Brainard's February speech shows this, once you get to 0, you stay.

"Forward guidance that commits to refrain from lifting the policy rate from its lower bound until full employment and 2 percent inflation are achieved is vital to ensure achievement of our dual mandate goals with compressed conventional policy space." 

Second, as the same Brainard speech shows, the Fed will consider some sort of YCC via caps on interest rates in the short to medium term part of the yield curve.

Conclusion: If the market has to entertain the lower bound, there are two key things that should continue to favor steepeners. 1) the very front end will continue to glide towards 0 while the belly of the curve is running out of room to rally if part of the response mechanism is going to be caps on the belly. 2) If the Fed were to do YCC type thing, 2s are anchored to the ELB, tenors outside the cap have to price a normal distribution + the floor of caps. Basically, if the market wants to price 0, the very front end has plenty of room to rally, that case is less compelling in the outer parts of the curve in a very mechanical sense.

Thanks for reading. best place for comments and feedback is by email, jonturek@gmail.com