Heavy take-up of Fed swaps eases strains on dollar

The dollar is on track for its biggest weekly drop in more than a decade, pulling back sharply after central banks tapped the Federal Reserve’s swap lines at the most rapid pace since the financial crisis.

The Fed has rekindled 14 swap lines with other central banks since the coronavirus crisis struck, aiming to ease a global shortage of dollars that had threatened to push the currency uncomfortably high at a delicate time for the global economy.

Five central banks borrowed more than $200bn under the facility in the week ending March 25, compared with just $45m in the previous week, helping them alleviate funding strains in their local markets. The European Central Bank and the Bank of Japan both drew the most dollars since 2009.

“Central banks have quickly accommodated funding demand for dollars and in doing so prevented a more destabilising liquidity crunch,” said Paul Meggyesi, head of FX strategy at JPMorgan in London.

The US currency had moved so high that some analysts were beginning to warn of the risk that central banks might sell dollars directly in the market to weaken it. But after bursting to a 50-year high on a trade-weighted basis, the dollar index weakened to 99.75 from 102.95 on March 19, losing 3 per cent in a week. 

Chart showing how central banks are scrambling for dollar funding

The measure of dollar borrowing costs, the cross-currency basis, remained elevated against both the Canadian and Japanese currencies, but the previously extreme blow-out in spreads in euro and sterling markets stabilised, allowing these currencies to regain ground against the dollar. The pound recovered to trade above $1.23 after hitting multi-decade lows last week under $1.15, while currencies such as the Australian dollar also bounced back.

Over the course of March, companies have scrambled for dollars to help cushion the blow of revenues lost to the pandemic crisis, while investors have sought out the US currency for its tendency to climb in times of stress.

The overwhelming demand threatened to introduce stress into other parts of financial markets. In response, the US central bank reactivated swap lines with the Bank of Canada, the Bank of England, the Swiss National Bank, the ECB and the BoJ, and later widened the scope of the facility to include several emerging market countries.

Despite the pullback in the dollar’s exchange rate, the currency is still 2.5 per cent stronger than at the start of the year. Eric Robertsen, global head of currency, rates and credit research at Standard Chartered Bank, said the magnitude and breadth of recent dollar gains suggest that financial markets have become “seriously impaired”. As such, he said, the currency has become the “barometer of the efficacy of the policy response to corporate credit difficulties [and] interbank funding challenges”.

In addition, JPMorgan’s Mr Meggyesi noted that since the last financial crisis borrowing in the US dollar has ballooned, led by emerging-market companies and governments. Any rise in the dollar makes those debts more onerous to repay.

Bank of America Merrill Lynch strategists said commercial banks in Japan, in particular, have increased their dollar-denominated borrowings to levels that make the BoJ’s dollar take-up “very limited,” relative to the sector’s exposure.

“[The swap lines] will do little to address a perhaps more significant underlying issue which is the currency mismatch on the books of end users such as non-US corporates with dollar liabilities,” said Mr Meggyesi.

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