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Wait…a liquidity crisis in the dollar?

Flooding the market with dollars, the U.S. Federal Reserve can’t seem to get them into the right hands, creating pockets of liquidity trouble.

Everything in moderation leads to a happy and healthy life, right? Not according to the U.S. Federal Reserve. Apparently, their motto is go big or go bankrupt.

For years Jerome Powell resisted the reach of Donald Trump grasping at lower rates. One pandemic later and we’re now discussing zero percent interest, expanding the balance sheet, and possibly buying corporate debt.

Yet for all their bravado, dollars aren’t filtering through to where they’re needed most. Even with money supply increasing at a rate that would have Paul Volker spinning in his grave, the greenback hasn’t reached the people desperate for it most.

Consumers struggle to get loans from banks, even though they’re awash with cash. Just in the last couple of months, major banks stopped accepting applications for home equity lines of credit.

Emerging markets already struggled before COVID to access supplies of the U.S. dollar. Now, with international trade and travel grinding to a halt, it’s created an enormous strain. In fact, Venezuela resorted to filling up a jet with gold bars just to enlist the help of Iran in dealing with Venezuela’s economic strife.

Surely these are limited circumstances where our fears are overblown. Quite possibly. However, given the currently restrictive nature of the U.S., could we be facing a global liquidity crisis in the U.S. dollar?

I’ll trade you a barrel of oil for a gallon of milk

Petrostates are finding it increasingly difficult to access dollars as the price of crude oil collapses globally. Everyone from Saudi Arabia to Russia is struggling to keep up with dollar-denominated debt payments.

In fact, Saudi foreign exchange reserves cratered to their lowest levels since 2011…and oil was much higher back then. On the other hand, Russia hasn’t had nearly as drastic of a drawdown, nor looks to be in any danger.

Super Fed to the Rescue

Knowing that these issues existed around the world, the U.S. Federal Reserve expanded currency swap lines to central banks around the globe. Normally, the Fed conducts these operations with its permanent partners in Canada, England, Japan, The European Union, and Switzerland. Amidst the crisis, they expanded the lines to Australia, Brazil, South Korea, Mexico, Sweden, Singapore, Denmark, Norway, and New Zealand for up to six months. On top of that, the Fed allows 170 central banks to buy U.S. Treasuries and trade them in for dollars under repurchase agreements (on a temporary basis).

So, why are dollars so desperately needed? Last year, the U.S. dollar was involved in nearly 90% of all foreign exchange trades. It’s not just countries, but foreign companies and institutions also rely on the dollar. Without access to the currency, these players would be unable to re-fund debts or take out new loans.

Ironically, this enables the Fed to pretty much expand the money supply (and U.S. lawmakers the debt) as far as the eye can see. The substantial amount of underlying demand means there will always be a need for U.S. dollars and debt. The creative programs implemented by the Federal Reserve, such as the repo agreements on treasuries, also incentive ongoing demand for U.S. debt.

Help me help you

While the Fed’s expanded lines certainly expand its reach compared to any other time in history, it simply cannot reach all corners of the globe. It simply hoped to stem a potential fire sale of U.S. Treasuries in an effort to acquire dollars.

Yet, as noted earlier, the Fed’s reach only extends so far. Periphery economies in the 3rd world and emerging markets only receive dollars through  trickle-down. With global trade at a standstill, many will soon struggle to acquire the needed currency, which would create volatility in trading pairs.

We need look no further than Turkey to understand the potential disaster faced by countries unable to keep up with general obligations. With dwindling foreign reserves of any kind and hefty debt, the country is forced to turn to allies for help, including U.S. swap lines. With tourism effectively halted, the country faces a significant risk of defaulting on its obligations in the coming months.

Currency market impacts

Traders could be caught off-guard as we head into the unknown. Many countries have only a few primary sectors they rely on for trade. As we’re seeing with Turkey, the pandemic upended those areas, putting excessive pressure on current debts.

From there, you get expanding risk of ‘irrational’ actions. For example, part of the drain on the Turkish foreign reserve came recently in an effort to prop up the Lira. While this wasn’t well-known initially, it nonetheless impacted Turkish Lira pairs trading.

Currency markets are still contending with Brexit, which hasn’t been finalized to date. Currently, negotiations hit a stalemate, though there isn’t as much emphasis on completing this with the pandemic in full swing. Actually, the Pound Sterling saw weakness recently as the Bank of England discussed negative rates as a possibility.

At the same time, President Trump continues to push the Fed towards negative rates, which they’ve so far resisted. Markets aren’t currently pricing in the possibility as a reality. However, if it becomes more likely, we could see a massive shakeup in the global currency markets overnight.

However, Japan has provided ample reason (among other nations) as to why negative rates don’t work. Heavily dependent on trade, the Japanese economy already slipped into a recession, and yet the currency hasn’t changed much since the beginning of April.

In fact, globally, most major currencies began trading in a range after a massive swing in early March. The exception being those like the Australian Dollar whose economy is tied closely to oil prices.

Final Thoughts

At some point, both equity and currency markets will break. Currency traders tend to practice hedging as a common practice, which can give them a leg up in volatility. 

Nonetheless, even with a world awash in dollars, it remains to be seen whether those reach the far corners that desperately need them, as well as main street consumers.