Special report: what’s next after panic USD buying?

• USD sees massive gains despite zero rates, renewed QE in the US
• Global markets witness a funding stress comparable to 2008
• EM currencies the most exposed, many see their all time lows

USD funding stress – why did it happen?

In normal times FX traders follow interest rate differentials. Currencies offering higher rates are – all else being equal – more attractive. Therefore investors track numerous economic reports to predict how interest rates could react. But times are not normal now. A widespread impact of coronavirus means that many businesses could find themselves at the verge of default. Under such circumstances it’s not surprising have second thoughts when it comes to extending credit. The problem is that during a period of panic this situation affects everyone and credit market freezes.

Global financial system is USD centric thus debt accumulation in recent years occurred mostly in the US currency. Source: Zerohedge

Since the global markets are USD centric, borrowers have little choice but to accept such exposure. Normally they can easily hedge themselves using swap transactions but if the market freezes they might be forced to buy USD on the spot market to for the contracts that they cannot rollover. Everyone at the same time. While the Fed launched USD swap lines with central banks, this has not worked out yet.

2008 vs 2020 – are there lessons to be learned?

EURUSD

We use 3 month EURUSD basis rate and FRA/OIS premium as metrics of USD funding distress and start with comparison to the EURUSD or actually USDEUR (reversed chart for convenience).

We can see that in 2008 there were 2 periods of distress: major one right after Lehman collapse (lasted nearly 3 months!) and a weaker one around February. USDEUR started rallying soon into this first period but reversed sharply once conditions improved in December. Then the US dollar rallied again sharply even though the second distress was weaker. The trend reversed in March. What were the turning points here? In late October, the Fed opened swap lines with central banks in Mexico and Brazil and on 25 November it announced the QE1. Then in March Bank of England announced its QE program. Source: Bloomberg, XTB Research

Turning to 2020 the USDEUR was falling sharply as the rate cut in the US narrowed a yield gap to the Eurozone but that move has now been reversed following the USD funding distress that is evident. One may assume that this funding crisis needs to be addressed for the main currency pair to recover.  Source: Bloomberg, XTB Research

EM currencies: USDMXN and USDPLN

First, do notice that EM currencies were entering the Lehman crisis overvalued (MXN) or extremely overvalued (PLN). Now the situation is strikingly different – most EM currencies are undervalued (here’s the trade weighted chart adjusted for inflation). So the entry point, probably limiting the downside but the dynamic is the same. Source: Bloomberg.

We can see that in 2008 both PLN and MXN reacted with major declines to the first funding distress. However, unlike the EURUSD, there was only a very minor correction in December and both currencies were losing very sharply until the peak of second funding distress. Source: Bloomberg, XTB Research

Turning to 2020, despite both currencies looking fairly/undervalued at the start, the response to funding distress is equally brutal. Here we show just these 2 currencies but it can be seen across the EM universe (BRL, CLP, HUF, RON, ZAR etc.). The latest data shows improvement in distress metrics but so far it has not translated to stabilization on the FX. Source: Bloomberg, XTB Research

S&P500 (US500)

For S&P500 we can see that limiting distress in December did little to calm investors in 2008 and just as with EM currencies, the index turned the corner in 2009 after the second round of distress stopped. Of course here, the transactional link is not as clear as with the FX so that could be just a proxy.  Source: Bloomberg, XTB Research

Turning to 2020, it’s clear that such a flight to USD is devastating for the global economy that’s already under massive burden. For the US strong currency means deflation risk and emerging economies (or even some advanced) it mean instability and lack of (so much needed) funding. Therefore, improving the funding situation is a prerequisite to any recovery. However, given a lesson from 2008 and a scale of economic damage that is just taking place now, ending the distress doesn’t need to coincide with the bear market bottom.

Conclusions

The one factor that central banks cannot control is a spread of coronavirus. There are concerns that a shutdown of the global economy will be long, dealing a massive blow. Central banks can and should try to contain the funding distress. Here many actions have already been taken – much sooner than in 2008. This might help EM currencies but there’s no guarantee. When it comes to indices, it looks like a full economic damage could still play out in weeks to come.