I remain focused on global central banks’ withdrawal of liquidity as the primary driver of markets this year, and in recent posts I’ve discussed how I think it’ll unfold. In short, I think we’re still in Phase 1, and it’s intensifying now as the dollar strengthens with higher interest rates in the US. Price action on Tuesday of this week was textbook Phase 1: stocks down, spreads wider, rates higher, volatility higher, and dollar stronger. While the data quality is weakening slightly, surprise indices are still positive, and as such, this tightening of financial conditions has yet to clearly impact the US data. I still think that arrives at some point soon, and that’ll be the opening salvo for Phase 2.
This week, I want to look more closely at what’s going on with USD liquidity from an offshore perspective. The onshore US financial conditions tightening we’re experiencing as Phase 1 appears to be affecting EM assets globally, and I believe the offshore dollar liquidity dynamics are the reason why. In this sense, EM is the canary in the coal mine for the offshore financial conditions tightening, which is partially a result of Fed actions, and could be exacerbated by trade tensions. Bottom line, offshore financial conditions tightening globally probably intensifies the effects outlined in the Three Phases model, but the international dynamics are complex, and only indirectly related to domestic US monetary policy tightening. I’m going to try to illustrate it anyway, with some simplification but hopefully not too much. My prior post, Cross Border Capital Flows: a Refresher on the Lingo, might serve as a reference if what follows sounds like mumbo jumbo.
The diagram below illustrates a hypothetical path of a dollar as it leaves the United States via the current account deficit, and eventually re-enters through the capital account surplus.
For countries who run current account deficits, but for whom there is no international demand for their currency as a reserve asset or medium of exchange, the entire right hand side of this diagram does not apply. Those countries purchase goods from abroad with their domestic currency, and that currency is immediately recycled back to the home country through the capital account (portfolio flow, foreign direct investment, or domestic central bank reserve depletion), because the currency in question has no offshore uses. The current account and the capital account must always balance for every country*, as in the “balance of payments.” However, for the USD as the most prominent reserve currency, there are many potential intermediate steps a dollar can take between its export through the current account, and its re-import through the capital account. In a nutshell the USD has offshore uses, which I try to show in a stylized fashion on the right hand side.
The USD is both the primary reserve asset for foreign central banks (orange box), as well as importantly, a preferred currency for global trade and international commerce (blue box). For both of these reasons, there is offshore demand for dollars as both a store of value as well as a medium of exchange. (Importantly, that demand is generally increasing over time, which we’ll come back to). Non-US banks commonly accept dollars on deposit, and in turn lend out those dollar deposits through traditional loans or dollar-denominated securities purchases (purple box). I label this the Eurodollar deposit market, though “Eurodollar” is often used more loosely. This is credit creation in the classical sense, where dollar supply originating purely from the US current account deficit acts like a monetary base, and then offshore USD bank deposits are created through bank lending, which is synonymous with increasing the broader money supply. In parallel, non-US financials as well as sovereigns and non-US corporates issue dollar-denominated bonds in the offshore market (tan box). This isn’t credit creation per se, because deposits in the Eurodollar system do not increase through these transactions, but the issuers raise genuine dollar financing for reserve accumulation, trade finance, or in the case of “high carry” currencies, for speculation given typically lower dollar financing interest rates.
Ultimately, USD deposits find their way to an end-user (orange box) who for risk tolerance and/or regulatory reasons chooses to reinvest the USD back into US onshore assets through the capital account. Whether that investment takes the form of portfolio flows (Treasurys, corporate bonds, stocks), or foreign direct investment (real estate, factory ownership, etc.), the dollars end up as deposits in a US bank with bank reserves at the Fed as the asset held against it.
The key variables which drive supply and demand for offshore dollar liquidity are how many rotations each of these various components of the system cycle through. If global trade volumes or reserve demand increase, then there is greater demand for USD as the medium of exchange and store of value. In much the same way as a central bank balance sheet must generally increase over time to achieve positive nominal GDP growth and a positive inflation target (see the seashell analogy in Printing versus Burning), there must be a generally persistent current account deficit from the reserve currency country to satisfy expanding offshore reserve currency demand for trade growth. Secondly, the number of times a USD cycles through the Eurodollar deposit credit-creation mechanism before it reaches an end user who repatriates it to the US determines the supply of higher-order monetary aggregates offshore (think M1, M2). Thirdly, the size of the offshore USD bond market determines the need for dollar liquidity for ongoing repayments or ever-growing (re-)financing needs. The size is big:
Now, tightening financial conditions onshore in the US increases the attractiveness of domestic US investments all along the risk and maturity spectrum, when compared to offshore equivalents which are also USD-denominated. Borrowing money is more expensive, which means investing money is more lucrative. Higher risk-adjusted returns for onshore USD investments essentially encourage an interruption to the Eurodollar deposit credit creation cycle sooner, i.e. after a fewer number of rotations, an end-user is enticed to repatriate the dollars to a US bank directly or via a US investment, which ultimately reduces broad money supply growth of USD deposits offshore. I believe this is starting to occur, and this drives up the USD exchange rates.
Emerging market borrowers across sovereigns, banks, and non-financial corporates, have been material issuers in the international USD bond markets, as represented in the chart above. A noticeable reduction of offshore dollar liquidity supply with no change in demand encourages capital to flow out of EM currencies and into dollars, especially when the countries in question have significant dollar liabilities. This is occurring, and is why the EM FX price action can serve as a canary in the coal mine for pressure in offshore USD liquidity.
I expect the offshore liquidity challenges will potentially intensify the impact of tightening US financial conditions, by providing a conduit for the monetary policy to extend globally. Interestingly, if EM FX is the canary for offshore dollar liquidity, it seems to correlate pretty well to changes in contemporaneous onshore US economic activity:
Finally, if efforts on the part of the Trump administration to reduce the US trade deficits are successful, the offshore supply of pure USD – the monetary base for global trade and reserves—will be curtailed. I expect if this were to occur, the price of offshore dollar bonds would be quite sensitive, given the large outstanding stock. So rather than just EM FX coming under pressure and the dollar rallying, you’d see actual deleveraging needs in the offshore USD debt markets.
*This is theoretically true, but there are reasons why the balance of payments may not balance in a given fixed time period, or may not balance over time if there is significant smuggling or other forms of shadow trade and investment occurring off the books. For purposes of my illustration here, I stick to the theory for simplicity.
The wake-up call
The spread between 30-Year LIBOR (London Inter-bank Offered Rate) and OIS (Fed Funds) rates, known as the basis swap has been trending higher for much of the last 12 months. In March, however, this little known and even less frequently traded market sent a warning shot across the bow of every LIBOR-based investor. In one week, the basis spiked by over 10 basis points (circled below).
While most of the flow was driven by a small investor base of levered investors who were trying to exacerbate quarter-end funding stresses in short-term borrowing markets, the impact was felt across all $150 trillion notional of interest rate derivatives (IRD) contracts (including options) that reference LIBOR. The $150 trillion dollar IRD market is further eclipsed by the overall volume (and notional size) of contracts that reference LIBOR (in any form), which is estimated to be more than double. This includes everything from the floating rate loan securities to the massive currency forward market. For this piece, we focus our attention primarily on the IRD usage by institutional investors, including pensions, insurance companies and endowments & foundations, with a particular focus on liability-driven investors.
The alarm clock is buzzzzzzing
The reality of LIBOR cessation is setting in. On December 31, 2021, the Financial Conduct Authority (FCA) will no longer compel participating banks to submit LIBOR quotes in which the market depends on to set the rate. In the meantime, the industry is busy collaborating on solutions for stop-gaps, contingencies and the eventual replacement and transition to a new “reference rate”, but the clock is ticking. The Alternative Reference Rates Committee (ARRC), chaired by the Fed, has decided on a Secured Overnight Financing Rate (SOFR), based on the deeper (more frequently traded) repurchase agreement (repo) market. SOFR was published for the first time on April 4, 2018, and the CME began trading SOFR contracts (similar to Eurodollars) on May 7. Since the inauguration of these new futures contracts, volumes and open interest has begun to rise and their potential as a replacement is promising. However, SOFR has a long way to go to establish enough credibility and serve as a replacement for the vast LIBOR-based market. Due to current regulations and the balance sheet intensive nature of repo financing, a term market (maturity points beyond 1 year) does not yet exist. To eventually trade a 30 year SOFR instrument, market participants will need time to become accustomed to trading before a well-developed forward curve can grow. The transition will be slow and painful but the market will likely migrate toward SOFR over the coming years. While LIBOR has been in place for decades, by the time it is phased out in 2021 SOFR will have had less than 4 years of market experience.
So what do we do in the interim? Even if we assume that SOFR becomes the new reference rate on December 31, 2021, we don’t actually have 3 years. $150 trillion in notional contracts can’t just be adjusted in one day. And how do we handle new hedges that are meant to last through (and beyond) the transition?
“The only reason for time is so that everything doesn’t happen at once” -Albert Einstein
December 31, 2021 is not the real deadline. In anticipation of the deadline, by 2020, the market will begin to shift to a new reference rate. While no one wants to be the first to move to a new reference rate, you certainly don’t want to be the last, or within the last third for that matter. As volumes begin to migrate, the liquidity in the LIBOR-referenced market will decline. Dealers will have little incentive to enter into new contracts using a soon-to-be-obsolete reference rate. Moreover, bid/ask spreads on LIBOR-referenced products will likely be widened to reflect the uncertainty of offloading the risk, the cost associated with novating LIBOR-referenced contracts, and the costs associated with collapsing legacy contracts within the intermediary community.
“The bell tolls for thee” -John Donne
There are many active participants in the IRD markets, but the typical end-user of IRDs (LIBOR swaps) are institutional investors, including pensions, insurance companies and endowments & foundations. With respect to pensions, investors typically maintain a derivatives overlay account in which they receive a fixed swap rate and pay LIBOR to extend the interest rate duration of their assets. This allows them to better hedge the interest rate sensitivity of their long-dated liability cash flows across the yield curve. Underfunded pension plans can take advantage of this market as well without needing a significant cash dollar allocation to interest rate sensitive fixed income assets. In addition to this capital efficiency, the institutional investor community was a big beneficiary of the collapse in LIBOR swap spreads, a privately negotiated spread over Treasury yields, which tightened from 50 basis points above Treasury yields before the global financial crisis to a level of 50 basis points below Treasury yields in late 2016. Similarly, insurers and endowments & foundations also benefited from transformations in the IRD market. Innovation has promoted capital efficiency which has allowed investors to preserve higher returns and introduced new asset volatility hedging approaches in the market, including tail-risk hedging. The risk parity community also uses the embedded leverage in derivatives contracts to balance out their risk profile across asset classes.
Fast forward to today, the average corporate defined-benefit pension plan is approximately 85% funded and approaching an allocation of 45-50% to fixed income with a higher asset duration (which includes an increasing allocation to derivatives as an integral part of the hedging strategy). According to the aiCIO 2017 Liability-Driven Investment (LDI) Survey, derivatives usage by pension investors has increased 126% over the past 3 years. These investors are increasingly comfortable with the benefits of utilizing exchange-traded and exchange-cleared instruments to enhance their hedging programs. Given the integration of LIBOR-based investment products into the pension community’s investment portfolio, it is a fiduciary imperative to search for and implement an alternative to LIBOR in a timely manner.
“Time moves slowly, but passes quickly” -Alice Walker
How do we get from LIBOR to SOFR as seamlessly as possible while remaining cognizant that liquidity in LIBOR-referenced markets could evaporate over the next couple of years? What temporary alternatives are there to hedge investors’ risks against the shift?
These are some factors to consider when deciding on a temporary solution:
Let’s focus on the comparable instruments that can be used. In order to do so, we must first understand the characteristics and benefits of the LIBOR-based swap markets:
Now let’s assess the alternatives to see how they hold up:
“Time Keeps on Slippin’, Slippin’, Slippin’ into the Future” -Steve Miller Band
LDI investors have their work cut out over the next couple of years. As illustrated above, there are no easy solutions. Treasury futures provide a strong alternative given their large liquid market would allow investors to adequately offload duration exposure relative to longer-dated liabilities. However, Treasury futures contracts don’t have the flexibility to be implemented across the full curve and must be rolled quarterly, increasing the governance burden. These contracts also don’t have the desired positive convexity to match pension liabilities, creating a sub-optimal hedge. Anecdotally, some of the swaps duration exposure has shifted to the Treasury futures markets, or more broadly, the U.S. Treasury STRIPS cash markets, where transaction costs and liquidity are higher and lower than futures markets respectively. Smaller trades can still be executed in the nascent OIS or SOFR markets, but unfortunately for many other large investors the more structured OTC markets (total return swaps) are the only other realistic avenue.
The transition away from LIBOR-referencing derivatives is a monumental task and fraught with uncertainty. There is no clear path, except forward. Investors are on the clock and the best approach is to be nimble and have a fluid plan. As the Rolling Stones wrote in the lyrics:
“Hours are like diamonds, don’t let them waste
Time waits for no one, no favours has he
Time waits for no one, and he won’t wait for me”
Establishing a plan early amidst a changing market landscape will help to mitigate some of the volatility over the next two timely years.