The demand for dollars worldwide is increasing, at a time when supply is decreasing, as the Federal Reserve Bank of USA has proceeded with a large interest rate hike and is abandoning monetary easing by now applying monetary tightening.
This situation may create conditions squeeze for US currency? And what will this mean for the “Eurodollar” market?
Some analysts, including Jeff Snyder, Brent Johnson of Santiago Capital, but also the Greek Michalis Nicoletos they predict that the new conditions will lead to US dollar shortages that may create a global liquidity crisis and that this trend will become more visible in the coming months.
This is the conclusion reached by an analytical study by the analyst, investment advisor and fund manager for many years, Michalis Nicoletou, entitled “The chronicle of an upcoming “drainage” of liquidity in dollars”.
Nicoletos points out that recent changes in US economic strategy are accelerating it shortage of US dollars on a global scale – a trend which, although already visible, is expected to manifest itself more visibly in the coming months, as the impact of these policies is usually felt with a time lag.
He also predicts that if the current course of US policy continues, severe US dollar liquidity will emerge, likely internationally, driving the price of the US dollar much higher. We are witnessing – he points out – politicians who essentially repatriate US dollars to finance widening domestic deficits, a mechanism that could exacerbate economic pressures for countries dependent on current account surpluses, notably China, as well as those burdened with increased US dollar debt.
Dollar behind 90% of buying and selling
The study analyzes the importance of the US currency for international transactions, as according to BIS report (Dec 2022) while global international transactions take place in more than 50 currencies, forex trading takes place in only a few major currencies. Almost it 80% of all foreign exchange trading takes place in the five foreign exchange trading centers. Average daily US dollar turnover on one side of the trade was $6.6 trillion – up by 14% from $5.8 trillion in 2019, according to the change in total turnover. This means that the US dollar was on one side of 90% of all foreign exchange trades.
Nicoletos also analyzes that the returns of US government bonds have become more attractive than deposit rates because banks cannot raise deposit rates as quickly, so money worldwide has flowed into Money Market Funds (MMFs) which invest in short-term debt securities such as Treasury bills of the US government. As a result, global US dollar deposits began to leave the global banking system and go to MMFs. This caused two issues: a) created a liquidity problem for banks, foreign and domestic, which may be forced to sell US government bonds at a loss (since their prices have fallen due to the increase in interest rates), and b) further drained global USD liquidity as everyone rushed to buy MMFs to take advantage of the interest rate differential.
The “key”, according to Nicoletos, is that the FED has made available to American banks the BTFP (Bank Term Funding Program)by which it provides liquidity to eligible credit institutions against a deposit of US Treasury bonds, which are not “cut” even if their market price has fallen, as is now the case due to rising interest rates.
In this way, the US made sure to protect US commercial banks by accepting US Treasury bonds as collateral at face value. So even if the bonds are trading at a price 90 and a US bank has to sell them at a huge loss for liquidity reasons, it will no longer have to.
However, this facility does not apply to credit institutions without US operations, and this creates an increased risk for the “Eurodollar” market.
The Eurodollar market is a global financial market in which US dollars are deposited, borrowed and traded outside of the United States. Despite its name, the usual definition of a Eurodollar is any US dollar deposited in a bank outside the United States (not just Europe). It is a decentralized market, meaning it is not regulated by any government agency.
The market Eurodollars it began in the late 1950s and early 60s, when Russian banks began holding US dollars in European banks. They did this to avoid US rules about how money could move in and out of the country. In the 1970s and 1980s, the market proliferated because banks and businesses “liked” the higher interest rates and fewer regulations compared to the US.
During the period of the Bretton Woods agreement, which tried to keep the value of the US dollar and the British pound within a certain price range, buying Eurodollars became a way for banks to circumvent the rules that had been put in place.
THE famous economist Milton Friedman found that moving US dollars abroad for better returns created new money supply outside the US. This growth only stops when banks run out of money to lend, often because of rules about how much capital they must hold as a reserve.
Today, the Eurodollar market is used by a wide range of participants, including banks, businesses, governments and individuals. It is a vital part of the global financial system, providing a source of liquidity and funding for international trade and investment.
BIS estimates that the Eurodollar market represents over 40% of the global OTC foreign exchange market and over 20% of the global derivatives market. This makes the Eurodollar market one of the largest and most important financial markets in the world.
Various sources calculate it from $5 trillion up to $20 trillion.
The big risk
The interest and the big risk, which Nicoletos points out in his study is that all those banking institutions (non-US) that are part of the Eurodollar market and that have participated in this process are not included in jurisdictions covered by swap agreements to provide liquidity in dollars that the FED has concluded, nor are they protected by the Bank Term Funding Program (BTFP) so in the event that the dollar squeeze actually occurs, a large part of this market will not be covered by the agreements entered into by the FED.
H Federal Reserve Bank of the United States has entered into agreements to establish central bank liquidity swap lines with six foreign central banks. These are the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, the Swiss National Bank and the Bank of Mexico under the NAFA agreement.
During the financial crisis of 2007, the swap lines of the Federal Reserve proved decisive in dealing with the crisis.
If a global liquidity crisis occurs, as it did in 2007, only six central banks now have a swap line with the FED to provide US dollar liquidity.
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