In the waning weeks of 1999, there was widespread concern that software programs might not recognize the number 2000 once the calendar turned from December to January, crippling computers and creating mass chaos in what was referred to as “Y2K.” We now know that didn’t happen, but those anxieties have a legacy in financial markets.
Ever since then, financial institutions and companies take extra efforts to fund their operations over the year end in what has become known as the “balance sheet effect.” This generally entails the hoarding of dollars, creating a squeeze in demand for greenbacks that can have a negative impact on markets and tighten financial conditions. The effect may be more pronounced this year as tensions around the U.S. debt ceiling and the competing Republican tax bills in Congress come together in a way that could cause the dollar to appreciate in value.
It may be happening already, as the dollar has strengthened from 3% to 5% against other major currencies since early September. A rising currency is normally not a bad thing, but the problem now is that it could exacerbate some negative trends in the markets. For example, there’s the potential for a strong dollar to drive up short-term interest rates even further. Also, credit spreads may widen as dollar rates rise, such as during the 2008 financial crisis when the London interbank offered rate, or Libor, skyrocketed.
To be sure, a full-scale dollar funding crisis seems unlikely, but all the ingredients are in place for some scarcity as the federal budget deficit increases and the Federal Reserve continues to shrink its balance sheet. The Republican tax plan is projected to increase the deficit by about $1.5 trillion over the next 10 years. To fund the deficit, the U.S. Treasury Department has indicated it will issue more short maturity debt. That could be a problem as the Fed reinvests less of the proceeds from maturing bonds that it holds into new securities.
In fact, this reinvestment is projected to turn negative in net terms by mid-2018. That’s already pushing yields on Treasury bills and notes significantly higher than unsecured borrowing rates such as Libor.
In terms of credit, think back to late 2015 and early 2016, when the investment-grade and high-yield bond markets suffered elevated stress amid speculation that a collapse in oil prices would spark a wave of defaults in the highly-levered energy sector. What happened then was that the dollar strengthened, contributing to a slowdown in the economy.
By February of 2016, central bankers gathered in Shanghai to address the dollar’s strength, which was pressuring credit markets globally, especially those in emerging markets that have large dollar-denominated debt borrowings. Aside from a spurt of strength at the end of 2016 year, the dollar has largely weakened, especially this year, and credit and emerging-market assets have appreciated substantially in value.
Demand for the U.S. currency dollars may also rise as borrowers seek greenbacks they can use to repay the $1.5 trillion of dollar-denominated debt coming due next year.
Demand for dollars also continues to come from investors in Europe and Japan seeking higher debt yields than they can get in their home markets. Two-year German and Japanese interest rates hedged to dollars are below U.S. two-year yields, giving investors in Europe and Japan an incentive to invest in dollar assets because of the higher returns. In fact, European investors now hold more than $2.5 trillion of U.S. credit assets, and demand may only rise as U.S. short-term rates continue to increase relative to Europe and Japan.
Demand for dollars can also be seen in the market for cross-currency basis swaps, which are derivatives that measure the cost of converting local cash flows into other currencies such as the dollar. Recently, the currency basis swap curves in euros, yen and Swiss francs have become more negative, suggesting rising demand for dollars as companies in those countries seek the U.S. currency over year-end.
Although synchronized global growth, strong earnings and moderate inflation have been key drivers for market performance this year, the weaker dollar has also been a boon because it allowed for easier access to funding. But now, all this may change as demand for dollars surge.
— For more columns from Bloomberg View, visit http://www.bloomberg.com/view.