response to a reader’s question
A reader asked me to comment on this post on the Zero Hedge website about a potential US$ funding shortage. The post was sparked by (is a rehash of) this recent commentary by JP Morgan’s currency strategist.
Let’s be clear that this is not my area of expertise.
Nevertheless, here goes:
the blogger
The Zero Hedge post, following the JP Morgan piece, observes that it has become unusually expensive to buy large amounts of US dollars. The last time this happened was just as Lehman was failing, signalling serious problems with the world financial system.
The post author concludes that because dollars are again pricy we’re warming up for another round of severe banking problems.
JP Morgan
I don’t think the blogger is correct. It seems to me he’s mixing up cause and effect. Also, this is not what JP Morgan is saying.
history
Back in 2008-09, the main issue was counterparty risk.
Bear Stearns, whose financial statements showed assets–mainly bonds, loan participations…worth about $80 ended up bankrupt, with those “assets” really worth close to nothing. Lehman’s value was coming under similar questioning.
The conclusion the financial markets drew was that maybe all the banks’ financials were similarly not worth the paper they were written on–and that therefore anyone you lent money to, even for a few days or weeks, might go under before you were repaid. So the wisest–and only–course was to lend to no one. The world financial system froze up.
An important leading indicator of this mess was the increasing cost of borrowing dollars to finance trade.
today
Today’s situation is very different. Two factors are involved in the current high cost of finding dollars:
–it’s cheaper to borrow in euros, hedge currency exposure and convert the loan proceeds into dollars than it is to borrow directly in dollars. (Similarly, in recent years it’s been cheaper for a Mets fan to fly to San Francisco to see the Mets play there than buy a premium seat at Citi Field.) Enough American corporations are doing so to dramaically up the cost of obtaining dollars. They will presumably continue to do so until do so until this arbitrage makes no sense.
–today’s carry trade is sell euros (or just about any other currency)/buy dollars.
my conclusion
Today’s situation, unusual as it is in post-WWII history, doesn’t signal the onset of a new banking crisis. Rather, it’s a function of differences in central bank monetary policy between the US and EU caused by differences in the relative economic health of the two areas.
an aside
JP Morgan mentions one thing for which it has no hard information but that may prove important.
The corporate borrowing situation described a few lines above makes no net impact (in theory, anyway) on the fx value of the euro. The currency hedging contract exactly offsets the effect of the purchase of dollars.
Suppose, though, US companies aren’t hedging. After all, multinationals have tons of money in overseas banks and lots of physical assets in foreign countries. Currency losses on both are currently ripping gaping holes in firms’ income statements. Companies might consider that having, say, euro-denominated liabilities would neutralize some of the damage (I feel confident that the JPM strategist has either made, sat in on, or at least heard about, financing pitches arguing US companies should do precisely this).
If so, their dollar-buying isn’t being offest by hedging contracts and is putting upward pressure on the US$.
equity implications
If so, once converting euros into dollars becomes expensive enough, US companies will presumably stop doing it. This could cause a significant bounce in the euro. This would likely switch European stock market preferences away from dollar earners toward (beaten down) domestic issues.