Huge moves in markets have been exacerbating the already high dollar demand in recent weeks. Drastic central bank action has helped mitigate this dash for cash but we’re still in exceptional times. The speed of the dollar squeeze this time can be seen clearly in currency basis swap rates across the Euro and Yen, and in the US Dollar Index (DXY). 

The currency basis swap rate reflects the premium added to US interest rates by lenders of US dollars to foreign borrowers. The more negative it is, the higher the cost of hedging US dollar exposures into local currency. The chart shows that Euro and Yen basis swaps have gone very negative (left-hand axis) and the US Dollar Index has shot upwards (right-hand axis).

.
.

Many ins­­titutional investors around the world hold large amounts of US assets which are hedged back into their local currency, a trend that has been increasing in recent years as US bonds offered higher yields than most developed markets. Recently, falling asset prices and dollar appreciation caused those investors to become over-hedged in US dollars. To bring those hedges back in line, they buy dollars and sell their local currency, thus creating a feedback loop that spurs dollar demand. 

Global central banks led by the Fed deployed an arsenal of measures to ease the dollar liquidity crunch, a vital step in restoring order to markets. In the past few days, the Euro basis swap has normalised, showing the Fed’s measures have been effective, and paving the way for some improvement in sentiment. The Yen basis swap is starting to normalise which is helping the Yen stabilise and offer defensive qualities again.

These tentative indications of stabilisation are welcome, but a return to normal is still some way off. 

Stuart Rumble

Stuart Rumble

Investment Director

Mark J Hamilton

Mark J Hamilton

Bob Chen

Bob Chen

Investment Writer