There’s been a lot of talk about dollar squeezes this week.
But it’s BNP Paribas who really explain the issue well on Tuesday. As they point out (in their daily FX strategy note) the prospect of quantitative easing in the third quarter led to a significant rally in ‘pro-cyclical and commodity currencies’ as investors prepared for potential dollar debasement.
What all these trades had in common was that they were all mostly dollar funded.
The unexpected dollar rally, therefore, is most likely causing a whole lot of pain in the market.
As BNP Paribas explain (our emphasis):
We had been warning since mid-October that any negative news can trigger a reversal in the short USD positions, and this has indeed been the case. The compounded effects of the problems in peripheral Europe, Asian inflation, and geopolitical risks have turned sentiment in the markets.
The pressure on pro-cyclical and commodity currencies is now coming to fruition as positions are being unwound, yielding a rally in the USD. AUD is most exposed to this move since it was the most favoured long position due to interest rate differentials and the country’s commodity edge.
The target of quantitative easing is to support asset prices via reducing real yield and rate levels and in turn stabilising the asset liability ratio which otherwise would be at risk of being adjusted from the liability side. The Fed wants to control the pace of financial de-leveraging via quantitative easing.
Higher asset prices and the weaker USD work in favour of the US economy. The side effect of QE is a weaker USD and in anticipation of the Fed launching its next round of QE at the beginning of November, the market had positioned it self accordingly in the months preceding.
Indeed, according to the analysts, an examination of US banks shows a significant decline in their net USD liability positions — even approaching a negative extreme.
As they go on:
This was evident in the US TICS data from October, which showed an USD218bn decline in USD liabilities vs. an USD150bn decline in August. This liability position has a tendency to correlate with the performance of the trend in the USD and is consistent with the decline seen in the USD seen since June.
This has been seen before, and the recent rapid build up of USD short positions approached the extreme levels seen in November 2009 and June 2008, which also coincided with the EURUSD developing a top.
This, of course, is hugely reminiscent of the situation that hit the market back in 2008. Only this time there is one big difference. It’s a much bigger problem.
Possibly even the unwinding of the ‘mother of all carry trades’ (to cite a Nouriel Roubini warning).
Or as the analysts put it:
In summer 2008 it had been European banks running an unfunded USD short position (bank asset position in the US funded in CHF, EUR, GBP), which the BIS estimated at that time at USD600bln. The potential USD short position the market potentially faces these days is much bigger.
And here, for clarity, is the current mismatch between the current net foreign liability position of US banks and the EURUSD — or what BNP Paribas describes as US banks’ funding of the global carry trade:
An update to this paper to be expected shortly then?
Related links:
The dollar shortage problem, evaluated – FT Alphaville
More on those USD swap lines… – FT Alphaville
The euro premium episode – FT Alphaville