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A dollar liquidity squeeze: echoes of the 2007 crisis?

A dollar liquidity squeeze: echoes of the 2007 crisis?

March 2018

Steve Donzé, Senior Macro Strategist

There's a global shortage of dollars. Here's why investors shouldn't ignore it.

Signs of stress are bubbling up in the banking sector in a development that has echoes of the 2007 credit crisis. Should investors pay attention? Yes, because, at the very least, it could weigh on European banks’ efforts to reduce debt and restore their financial health.

The problem is a spike in the differential between LIBOR and the Overnight Index Swap, or the premium over the risk-free rate non-US banks pay to borrow dollars outside of the US.

The spread has risen to 42 basis points, the highest since February 2012, and up from 25 basis points at the start of last month and just 10 basis points in November.

While the rise does not pose a systemic risk, it has nevertheless raised the cost, and reduced the availability, of dollar-denominated loans for non-US banks by a considerable margin and in short space of time. 

Moreover, the increase is neither a transitory nor technical phenomenon; it reflects deep-rooted changes in US fiscal monetary and policy.

As Washington tries to plug the hole in the federal budget, the issuance of US Treasuries is expected to surge. In this fiscal year alone, the government is expected to sell at least USD955 billion of new bonds, an 84 per cent increase on the previous year. The prospect of a supply glut, combined with the US Federal Reserve’s move to shrink its holdings of bonds by USD420 billion in 2018, is squeezing up rates on short-term instruments such as commercial and bank paper.

Offshore dollar borrowing costs are also rising because US multi-national corporations are repatriating cash held in overseas money market instruments to take advantage of a one-off tax break.

The liquidity squeeze may weigh particularly heavily on European and Japanese banks which are the most dependent on dollar funding. They don’t seem to be facing a dollar shortage yet, but the first signal of stress will come if they begin tapping into the dollar liquidity swap lines provided by the European Central Bank, the Bank of Japan and the Fed.

Freshly Squeezed
The dollar LIBOR-OIS spread has risen to a six-year high
Source: Thomson Reuters Datastream. Data covering period 31.12.2009 - 09.03.2018.