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November 23, 2017 at 07:51 PM
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.
(Related: Trump Debt Limit Deal Undermines Trust Among GOP on Tax Overhaul)
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.
(Image: iStock)
