Excerpt From Charlesworth & Rugg's Q1 2020 Newsletter

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Like the Great Financial Crisis of 2008, the coronavirus panic has slammed into asset markets and the global economy. In times of panic, everyone from institutional to retail investors tend to rush for the exits, read: cash, or US Treasuries. This “flight to safety” phenomenon can create additional problems for financial markets as participants rush to sell certain “risky” bonds, loans, currencies, and stocks in order to find safety in cash or highly rated sovereign bonds such as Treasuries. The problems can start to occur when these risky investments are not denominated in US dollars, but instead in euros, yen, or another foreign currency. In order to purchase US Treasuries or other dollar denominated assets that may be considered “safe”, the buyer must have US dollars in order to complete the transaction. In normal times, trading volumes are lower and there aren’t as many participants crowded in one direction. However, what we have seen recently is an increased difficulty in obtaining dollar funding outside of the United States.

US Treasury Market Stress

Nowhere has this been more evident than in the market for US Treasuries themselves. The market has a total size of approximately $17 trillion, with the various bonds and bills normally trading in very narrow price bands over the course of any given day or week. In March, we saw wild swings in the Treasury market, with bonds moving anywhere from two to ten times their average daily price ranges. Price changes that used to occur over months happened in hours, then reversed course again. These types of moves were large enough to cause significant alarm among even seasoned traders of Treasuries.

Two other commonly watched indicators also signaled difficulty in sourcing USD. One is the premium non-US borrowers are willing to pay to access dollars – gauged by the 3-month EUR-USD and 3-month USD-JPY swap spreads. As seen in the graph below, these spreads have moved sharply wider (indicating it is more expensive to borrow dollars). The second indicator is a measure of the health of the banking system known as the Libor-OIS spread, which represents the rate at which banks are willing to lend to one another. As of mid-March, this spread was 76bps, up from 13bps on2/21/20 prior to the coronavirus volatility. For reference, Libor-OIS peaked in 2008 around 365bps.

What could have caused a dollar shortage enough to roil Treasury markets within weeks of the crisis beginning? Debt. Approximately $30 trillion of it.

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The Bank of International Settlements (think of it as the central bank for central banks) has estimated the outstanding amount of dollar-denominated bonds issued by China, emerging and European countries is now $60 trillion, up from $30 trillion in 2008.

US Status as the Reserve Currency

The US Dollar has long been the global reserve currency, which allows the Fed to ramp up stimulus massively because it knows the world needs dollars to make up their own dollar-denominated shortfalls. In addition to there being $2 trillion of dollar-denominated maturities in foreign debt in the next 2 years, there is an existing shortfall of $13 trillion globally as of March 2020. This means the Fed can increase its balance sheet and support a large deficit increase because of the external demand for dollars. We find ourselves in an increasingly complicated global financial and commercial system, where the supply and demand for certain currencies can confer disproportionate amounts of economic power.For now, the US is the beneficiary of the system because we are the reserve currency in demand. Seeing the scramble for dollars should be a sharp warning for all market participants that issuing and funding debt across currencies isa critical activity with potential far-reaching and unforeseen consequences.  

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