Central banks’ demand for dollars is running below levels experienced in the financial crisis, signalling that the Fed’s move to flood the markets with funding has eased fears that the global lockdown could trigger a financing crunch. 

The Fed opened dollar swap lines with more than a dozen other central banks in March as the dollar surged and demand for the currency created severe shortages in the early stages of the crisis triggered by the pandemic. As the dollar is the world’s reserve currency, investors in times of stress seek shelter in the currency and dollar-denominated assets.

But demand for the Fed’s supply of dollars has not so far outpaced the levels seen during the financial crisis, the last time the Fed rolled out similar liquidity-boosting measures. 

A total of $447bn had been drawn down by other central banks by the end of the first week in June, Fed figures show — below the $583bn taken up in December 2008 at the height of the financial crisis. Fed chair Jay Powell noted on Wednesday that “market functioning has improved since the strains experienced in March” while insisting the Fed would continue to support financial markets for many months to come.

The majority of dollar funding has gone to the European Central Bank and the Bank of Japan but Mexico and South Korea have also tapped the Fed for dollars — the first time central banks in emerging markets have done so.

Now, as the first of these contracts begin to mature, central banks must decide in the coming weeks whether to replace them or return to the financial markets for dollar funding, as they normally do. The first ECB and BoJ swap contracts mature on Thursday; those signed by South Korea and Mexico start to follow two weeks later.

“It will be important to see if this dollar funding gets rolled [over],” said George Saravelos, global co-head of foreign exchange research at Deutsche Bank, who added that it would be an indication that investors were “getting more confident on dollar funding” and becoming less gloomy about the global economic outlook.

“There is a good chance we may be at the turning point,” said Derek Halpenny, head of research at MUFG Bank in London. “[Data] suggests appetite is peaking and any take-up is starting to be offset by maturing positions.”

Chart showing trade-weighted dollar index, suggesting an easing in investors’ liquidity scramble

That is reflected by a recent reversal in the dollar in cash currency markets, which has helped ease financing conditions outside the US; a weaker currency makes it cheaper for dollar borrowers outside the US to pay off debts.

Emerging economies were hit particularly hard by the dollar’s strength during the early stages of the coronavirus crisis, as their own currencies collapsed to historic lows. The overall size of the global liabilities denominated in the US dollar stands at $12tn, or 60 per cent of US gross domestic product, according to JPMorgan.

“A weaker dollar would help ease global financial conditions and make dollar-funding pressures . . . less acute,” said Ed Al-Hussainy, a senior analyst at Columbia Threadneedle Investments.

Column chart showing maturity profile for dollar-denominated bonds issued by corporations and governments ($bn)

The dollar’s depreciation has mixed consequences for the US economy. In the past, a cheaper exchange rate helped boost the competitiveness of US exports; the collapse of global trade has made that temporarily irrelevant. Instead, the focus in the US has turned from exports to financing the deficit and maintaining the ability to borrow cheaply — and a stronger dollar can help with that. 

Investors seeking dollar-denominated assets boost demand for US Treasury bonds, pushing down Washington’s borrowing costs; yields fall when prices rise. A strong dollar also makes it cheaper for US companies to finance their debt.

As a result, US president Donald Trump has shifted his tone. In the three years since he took office Mr Trump regularly complained that the dollar’s strength was damaging the US economy. But last month as the dollar strengthened, the president told Fox Business Network that “right now, having a strong dollar is a great thing”, though he could “live both ways” when it came to the US currency. 

“[Mr] Trump was initially focused exclusively on trying to boost exports and limit imports, but now appears to be taking a more balanced approach,” said Paul Ashworth, chief North America economist at Capital Economics in Toronto. 

Daniel Hui, global head of foreign exchange strategy at JPMorgan, said: “When currency competitiveness is far down the list of factors hindering exporters and growth, it is probably not surprising that the president’s language on the dollar has shifted.”

But the rate cuts imposed by the Federal Reserve in an attempt to stimulate the US economy have eroded the appeal of dollar-denominated assets, by bringing bond yields closer to those in other markets. Goldman Sachs expects foreign investors to be net sellers of US Treasuries this year.

Chart showing accumulated non-resident portfolio flows during periods of turmoil ($bn) comparing coronavirus with the financial crisis of 2008, the China scare of 2015 and the taper tantrum of 2013

Praveen Korapaty, chief interest rates strategist at Goldman Sachs, said: “This is unusual — foreign investors have net sold US Treasuries only in three of the last 20 years, and 2016 was last time this occurred.”

Although that will leave the US relying on domestic investors to finance its deficit, it helps emerging economies. After record capital outflows of $83bn in March, some investors are returning — $23bn found its way back in April and May, estimated the Institute of International Finance, a trade body.

But Simon Quijano-Evans, chief economist at Gemcorp Capital, said market sentiment could deteriorate at any time as the spread of the pandemic in Europe, Asia and the US and the possibility of another wave of lockdowns continue to drive capital flows. 

This could lead to sudden surges in dollar demand at times of stress, meaning the need for the Fed’s swap lines would persist, he said.

“The facilities need to stay in place until we really know that the virus is defeated,” said Mr Quijano-Evans.

Additional reporting by Jonathan Wheatley

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