Everywhere You Look There's a Dollar Shortage

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In November 2014, Apple sold about $3.5 billion in bonds that management claimed would be used for "general corporate purposes", including the possibility of funding dividend payments and share repurchases. The antiquated, backward US tax code makes Apple's foreign profits and cash out of reach for any such objective, so the massive financial engines of Wall Street are needed to fulfill the apparent demand. That was true in this case in more ways than one, as not only did Apple need underwriters for the bonds it needed dollars once they were sold.

The bond sale occurred in Europe in euros, meaning that unless the company wished to hold the proceeds in that currency for purely European business (not shareholder financialism) there would have to be some extra finesse. Thanks to the ECB, loan and bond rates in Europe especially for top-notch obligors like Apple have diverged significantly with the rest of the world except Japan (which is important). Taking advantage of the borrowing disparity, however, requires big financial connections.

To repatriate the proceeds of the euro bond sales means a cross currency basis swap (perhaps a plain vanilla currency swap, but not as likely). In this arrangement (and probably structured as several individual trades pieced together) Apple will have engaged some counterparty to exchange notional values up front in promise to do so again in reverse at an agreed upon future date. The notional values are usually determined by the current spot exchange of the two currencies (perhaps forward currency rates on occasion), meaning that exchange risk is eliminated since both parties make the same principal payments only offset by time (I borrow $3.5 billion from you today and give you $3.5 billion next year; you give me €2.8 billion next year in exchange for the €2.8 billion I lend you today). The financial end comes in on the interest, meaning that what is swapped is really payment streams.

Apple's bond sale in November 2014 really raised €2.8 billion, meaning that to convert the whole would have required a counterparty to engage a cross currency basis swap exchange of $3.5 billion. Having essentially borrowed dollars with its borrowed euros, Apple will pay its counterparty a floating rate based on US$ LIBOR; its counterparty will pay Apple the same maturity but at a Euribor plus a spread (which can be and often is negative). Everyone is happy, including the economics textbooks.

Despite being a cash machine, Apple has been busy on this account selling another €2 billion in bonds last September, bringing its foreign borrowing totals to the equivalent of $55 billion dating back to 2013. The company still intends to diversify its borrowing capacity so that by 2017 $200 billion has been borrowed outside the dollar, but there is a growing problem with that plan (though, to be clear, Apple, specifically, has never expressed or alluded to any difficulties). Systemically, the cost to convert foreign currencies into dollars, really "dollars", has grown over the past year - by a lot.

Economic and finance textbooks assign corporate roles into these kinds of swaps and financial arrangements because that is how this kind of finance is framed - as if it were the real economy driving these volumes and banks merely standing by to provide a natural need. The generic example in every exemplary I have ever seen (admittedly not a robust sample by any stretch, but I count that as a positive) has Company A swapping with Company B. Even in the world's first major reported interest rate swap that wasn't the case, as IBM engaged the World Bank in 1981 to swap payments and currencies across several denominations and borrowing rates. In other words, there is often a bank as counterparty, and just as much on both sides.

The cross currency basis swap is somewhat unique in that by fixing exchange values at both the outset and back end, it reveals purely financial perceptions in its values and changing values about the differences in interest payments. For example, in the 1990's the basis swap for Japanese banks (again, not companies) was structurally negative, meaning that they had to pay a premium to swap into dollar funding because of negative perceptions of creditworthiness. This is the legacy of the downside of the "global dollar short", as Japanese banks had accumulated large dollar asset positions (long US$ assets, short US$ funding) leaving them susceptible to such vagaries in dollar funding, whether repo or basis swaps or anything else someone on Wall Street or in London might dream up that wasn't gold or actual cash.

That negative basis swap has appeared again in yen terms, notably in 2008 and 2011, but has hit a record negative only recently under Governor Haruhiko Kuroda's madness in NIRP. As Japanese government bonds continue to yield more and more negative, with increasing participation across deeper and steeper maturities, that suggests not just banks inside Japan shifting liquidity preferences out of "bank reserves" being hit with Kuroda's "tax" and into government bonds yielding less negative, it also suggests basis swaps.

The negative yen basis swap acts like leverage where even yields on the interim "investment" are negative. Any speculator or bank with spare "dollars" could lend them in a yen basis swap meaning an exchange into yen. Because you end up with yen you are forced into some really bad investment choices such as slightly negative 5-year government bonds, but that is just part of the cost of keeping risk on your yen side low. Instead, the real money is made in the basis swap itself since it now trades so highly negative. The very fact of that basis swap spread means a huge premium on spare dollars; which is another way of saying there is a "dollar" shortage. Because of the shortage and its premium, you can swap into yen and invest in negative yielding JGB's in size and still make out handsomely. There has been, in fact, a rush of foreign "money" into Japan to take advantage of this dollar shortage; the fact that there has been such enthusiasm and it still has not alleviated the imbalance proves scale and intractability.

It is global, and it has mystified all the usual commentary and reporting. Basis swaps are highly negative in yen, somewhat so in euros, and increasingly so in sterling. The last time basis swaps were so widely negative was 2011 when especially the euro basis swap was front and center. The negative spread at that point was both a commentary on "dollar shortage" as well as the reason for it, namely the perceived creditworthiness of European banks that still required massive dollar funding - exactly like Japan in the 1990's. Though basis swaps have not reached those proportions of late, the possibility of something similar is being roundly dismissed in the mainstream because of Apple.

In other words, what you will see reported is the most benign and charitable of explanations for these peculiarities, especially as they align so closely in theory to the textbook case. Chalked up to divergences in monetary policy regimes, the Fed "tightening" and everyone else "accommodating", corporations are "forced" to borrow increasingly outside the dollar raising the demand for swap counterparties to bring those proceeds back inside the dollar. Such imbalance owing to a perfectly natural and even healthy trend is just finance working out Janet Yellen's confidence.

As you can imagine, the attempt at redefining the alarming in such comfortable terms fails on several major accounts, not least of which is why nobody is pouncing in size on these arbitrages. The most obvious counter explanation is the most general, meaning that since the first appearance of negative basis for these currency transactions we have seen nothing but global "dollar" turmoil. Are we supposed to think it is all just one huge coincidence that these deep-end eurodollar trades suggest a huge and global dollar shortage and then the world experiences two massive, sustained liquidations that happened as if there was a very desperate shortage of dollars?

To the mainstream it has to be random chance because the Fed "flooded" the world with bank reserves, so much and so apparently effective that they have declared it a success and stand ready to unwind (though not in actually shrinking). There are $2.5 trillion or so in the difference between the Fed's asset side and the other "absorptions", suggesting to a traditional frame of reference more dollar liquidity than anyone might ever need.

As I have to point out repeatedly, though, a balance on account with any one of the twelve Federal Reserve Bank branches is not usable in that current format. To turn those "reserves" into "money" requires at least one additional step - bank intermediation. In reality, it requires several as the only banks holding those huge balances are the chosen few primary dealers. In order for dollar funding to flow into cross currency basis swaps in such a volume as to alleviate all these very "healthy" strains of corporate real economy positiveness would actually require many steps of intermediation from primary dealers through money markets to other dealers who might be willing to carve out balance sheet capacity to fund as basis swaps counterparties.

With banking supposedly fully healed and fully resilient, this should not be a problem. In Janet Yellen's view, the economy is terrific and banks are flush with liquidity so there really should be nothing plugging the pathways to balance sheet capacity flowing wherever and however, taken to allocation only by the plethora of profit opportunities for all those bank reserve dollars. You can start to appreciate why it is so difficult to find some explanation that fits between a growing sense of unease, actual outbreaks of severe unease, and then the Yellen narrative. The mainstream's job of just explaining all this away is almost impossible.

It is not the first time corporate debt has been tasked to serve in this capacity by mainstream bewilderment, either. Curiously, interest rate swap spreads were at first conditioned to an overabundance of corporate bonds when they first appeared - also about a year ago (imagine that). An interest rate swap spread is entirely of and about dollars, comparing the same maturity interest rate swap (quoted as the fixed payment) against a US treasury yield. A swap spread indicates credit risks in especially interbank markets because, unlike the textbooks, it is mostly if not all banks carrying out the transactions. A negative swap spread, then, suggests there is less risk among global banks than the United States government.

In reality, however, it suggests no such thing; what it does indicate is that despite what is really an arbitrage opportunity and with some great size potential no bank(s) is (are) willing to offer enough balance sheet capacity to right the risk perceptions and get swap rates back above their companion UST yields. In other words, a shortage of balance sheet capacity which, in the 21st century banking world, might as well be termed as a "dollar shortage." Two entirely different swap regimes yet same conditions, results and interpretations, and, more importantly, occurring simultaneously while predicting and continuing through those liquidations.

One not fully swayed by textbooks or Janet Yellen's narrative might get to thinking that there was something really wrong with global banking. In fact, the burden of proof is actually on the other side, meaning that "something wrong with global banking" so easily fits within the current shape of the financial world that the dominant, mainstream message is the one that is so absurd that it should be dismissed outright unless backed by something more than Apple, Inc.

Unfortunately, the anecdotes do not end there. The nation of Egypt, for example, has been noted in recent years more for political turmoil than anything else. It might not be surprising, then, to find financial difficulties accompanying those circumstances even if lingering for years. Earlier this week, the Central Bank of Egypt auctioned $200 million to internal financial firms at 8.85 Egyptian pounds per dollar rather than the prevailing exchange of 7.73. The black market price of pounds has dropped precipitously of late, reaching nearly 10 pounds per dollar and suggesting that the central bank is being ripped toward devaluation by significant and sustained pressure.

That pressure?

"With nearly 90 million people, the Arab world's most populous nation procures about 10 million tons of wheat a year to meet domestic needs for subsidized bread, making it the largest buyer of the grain globally. The cheap-bread program, for which around three-quarters of Egyptians qualify, has been in place for more than 50 years, but the cash crunch and a deficit are pushing the government to reassess the allowance.

"The dollar shortage is affecting Egypt's businesses as well. For the first time in four decades, Egypt's largest assembler and distributor of passenger vehicles halted production at some of its plants as the dollar shortage limited its imports.

"A nearly three-week suspension of its assembly units in September and October cost GB Auto SAE at least 20% of its quarterly sales, said Menatalla Sadek, the company's chief investment officer. ‘We just didn't have access to the dollars we needed to buy vital parts to keep the units running,' she said."

The whole world is offering huge premiums in all sorts of formats, methods and expressions of "dollars" and yet "somehow" nobody wishes to offer them. If the US$ system were truly fine, then what a time to be a dollar owner. It seems to be, at the moment, the most valuable commodity around even when its form can be as disparate as a hugely negative basis swap to a loan to a cash-starved Egyptian company at 10 pounds to the dollar (funded at around 8). The world is the dollar's opportunity, so where are they all? This is exactly what the "rising dollar" means, where something in increasingly short supply leads not just to higher prices but actually increasing demand, too. In other words, a "short squeeze."

Argentina, Nigeria, Brazil...China. And many more that have been kind of forgotten since the violence of a global dollar shortage has moved attention toward now the biggest participants. The world is synthetically short the dollar and was increasingly so especially from 1995 to 2007 (August 9, to be specific). Nobody still has any idea just how "short" which is one reason why 2008 was so devastating; it wasn't just that the Fed was using 1950's understanding to counteract 21st century wholesale banking imbalances, they were so enormous that even if the Fed had figured it out it probably would not have been enough (witness the last wave of liquidations in early 2009 that came after all the dollar swaps, TARP, QE1, etc.

In October 2009, the BIS published what has been an entirely too lonely paper (one that I refer to repeatedly) that attempted to actually quantify the "dollar short" - and came up, pardon the pun, short. For European banks alone, the paper estimated that just their funding gap was $1 to $1.2 trillion. Of that, $432 billion was solved by ultra-short term interbank rollovers, $386 billion in central bank borrowings (not the Fed), leaving $315 billion for FX swaps. That was just what the BIS could quantify, as the true scale of the European dollar short might have been at least $2 to $2.2 trillion and perhaps as much as $6.5 trillion, all to be solved by these various and poorly understood mechanisms and transactions.

That was all before 2008, though, meaning the quantities and really the composition of the global dollar short is different today; maybe vastly different. I would argue, and do constantly, that the "short" has in many ways migrated to Asia and Emerging Markets, but even that is too nonspecific to be helpful. Chinese corporates, for one, have (had) been busy participants in borrowing in what the BIS terms Offshore Financial Centers (really just the same eurodollar cities that have existed as money centers since back when there was actually money in these centers). Of those corporate borrowers, the BIS figured in 2013 that about a third were financials sourcing offshore "dollars" for further lending inside China - China has had a "dollar short" for a long time, one that expanded greatly since 2012.

One of the main sources of "dollar" supply for China was undoubtedly Japanese banks. They had developed closer ties with Chinese firms as more Japanese producers relocated industrial capacity offshore and Japanese banks were "forced" to look overseas for more appealing "investments." BIS data estimates that banks in Japan increased overseas lending by $360 billion to $3.6 trillion in the three years ended last September. To accomplish that lending growth would have meant Japanese firms "borrowing" "dollars" through cross currency basis swaps.

In other words, Japanese banks are now on the wrong end of negative basis swaps, having to pay greater and greater premiums to continue lending dollars they don't have to Chinese firms that need them to engage in trade because the PBOC has based its entire monetary framework on reserves that are nothing like reserves. That is, essentially, the eurodollar system that can, in some periods, operate on what appears to be a stable basis - so long as there are banks willing to participate with their balance sheet capacity to maintain specific tolerances (spreads) of all these various parts. The problem with such a convoluted system is that it may not take much to push it outside of tolerances that only fashion further systemic cascade; and you could never know or guess when that happened, only sit astride the gathering wreckage and marvel at it, as especially the monetary "experts" tell you there is nothing wrong with any of it. It is the proverbial butterfly effect.

In the case of just Japan, we have the self-reinforcing cycle likely already set up and explaining the record negative basis swap - as the general dollar shortage starts to increase the negative basis spread it makes Japanese banks formerly supplying (really transferring) "dollar" elsewhere pull back, leading to a bigger systemic shortage which makes it even more expensive for Japanese banks and so on.

Everywhere you look, from these deep and esoteric internals to just commodity prices like oil, there is a dollar shortage. To which the most common response is one of cheerful embrace as if it were just another day in the life of the eurodollar system. It is worth remembering, however, that the basis of that believed nonthreatening interpretation relies on an institution (the Fed) and a discipline (orthodox economics) with a track record behind perhaps only the Soviet Politburo and current Venezuelan government in economic and financial planning prowess. Political upheaval globally can easily be laid at the doorstep of monetary politics on just that account.

It all declares a lot about just a singular "rate hike" through March 2016 where there was once not all that long ago supposed to have been five or six by now - "global turmoil" and all that. After predicting nothing but full and inarguable recovery, belatedly, since 2013, not even the Fed's own models believe it anymore. A lot of banks did, paid the price and are paying still to an as-yet unknown degree. They have all but announced that they will be tardily joining their peers in exiting the dollar business as prudently as possible. In time, that might even leave things like cross currency basis swaps to just the corporations, so maybe hang on to the textbooks after all. The world's credit-based reserve currency is strongly asserting, however, that only a small number of chapters in them were ever relevant.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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