In the huge earthquake in the financial market caused by this epidemic, the "dollar shortage" and the huge shock in the US bond market caused by the closing of the position of hedge fund are the two most popular hot spots. What is the chain behind this turmoil? With the provision of liquidity from the central bank, can the situation completely improve?
In this regard, the Bank for International Settlements (BIS), known as the "central bank of the central bank", recently released two key studies - "Dollar funding costs during the Covid-19 crisis through the lens of the FX swap market", and "Leverage and margin spirals in fixed income markets during the Covid-19 crisis", and made corresponding discussions.
BIS believes that the main reason for the "dollar shortage" is that the market supply and demand imbalance is intensified under the crisis. After the Federal Reserve and global central banks swap quotas were launched, the "dollar shortage" eased, but the foreign exchange swap basis is still larger than that of normal times; the reason for the sale of US bonds is that institutions usually obtain high leverage through cheap financing, but when volatility soars, the positions of leveraged funds that cannot meet margin requirements will be forced to level, which further pushes bond prices down, so regulators need to strengthen the stress test of related markets.
From the foreign exchange swap market, the "dollar shortage"
Since the outbreak of the epidemic, the cost of US dollar financing has soared. In the BIS's view, the understanding of the "dollar shortage" needs to start from the perspective of both supply and demand parties, and the derivative market with the largest trading volume - foreign exchange swap, is a good observation window.
BIS believes that basis is a good indicator for observing the degree of "dollar shortage". Many non-US currencies holders around the world pledge non-US currencies and integrate into the US dollar through swap markets.
Specifically, the operation process of CCB cross-currency basis is: in the initial stage, for example, the borrower lends 100 million euros to Institution A and then receives 110 million US dollars from Institution A (assuming the exchange rate is 1:1.1); during the valid period, since the borrower borrows US dollars, the capital cost is based on LIBOR (London Interbank Offer Rate), and the actual capital cost of the borrower is LIBOR-EURIBOR (Euro Interbank Offer Rate)-α (i.e. basis value). The lower the α (the deeper the negative value), the more unfavorable it is to the borrower, indicating that the "dollar shortage" is more serious.
In recent weeks, the basis of foreign exchange swaps has expanded dramatically. BIS mentioned that starting from mid-March, the basis expansion was significant, especially in the short term, the three-month basis of the US dollar to the Japanese yen expanded to -144bp, the US dollar to the euro to -85bp, the US dollar to the Swiss franc -107bp, and the US dollar to the British pound -62bp. What exactly causes this situation
? BIS believes that this reflects both supply and demand factors.
From the demand side, the demand for US dollar financing has increased in recent years, which can be reflected in the rising demand for to hedge by non-US companies and portfolio managers. They exchanged local currencies for US dollars and obtained US dollar financing based on foreign exchange hedging. Among them, institutional investors (insurance institutions, pensions, and other asset management companies) play a key role. They own local currencies but have a global diversified portfolio (largely denominated in US dollars). The size of their portfolios has risen sharply after the 2008 financial crisis, which has also led to a growing demand for US dollar financing.
In terms of the supply side, the US dollar is provided by banks and other financial intermediaries. Financial turmoil caused by this epidemic has exacerbated the shortage of bank hedging services because banks are more conservative during crisis times. Meanwhile, businesses are eager to raise funds during the crisis by overdrafting lines of credit, which has led to other forms of bank loan shrinkage. In addition, high-quality money market funds are generally providers of the US dollar, but these funds have experienced a large amount of redemption during the epidemic, resulting in a contraction of the US dollar supply, which has led to a continuous expansion of the foreign exchange swap basis.
Review the global financial tsunami, the Federal Reserve used currency swaps to alleviate the dollar liquidity problem of other central banks. This time the Federal Reserve also launched a similar policy. The "dollar shortage" eased after the central bank swap quota was launched, but the basis was still larger than that of normal times.All walks of life believe that currency swaps should not cure the root cause, and the root cause must be solved by the Federal Reserve to maintain the US dollar's credit expansion system without collapse.
Hedge funds are forced to close their positions and exacerbate their U.S. bond sell-off
In the previous financial market turmoil, a large number of hedge funds were forced to close their positions or sell their positions, including the well-known Bridgewater. At the same time, safe-haven assets, U.S. bonds began to sell off on March 9, and the yield on ten-year U.S. bonds rebounded from below 0.4% to above 1%. What exactly happened behind this?
BIS believes that hedge funds that adopt relative value strategies and risk parity strategies have all exacerbated the previous turmoil in US bonds.
Hedge funds that use the so-called relative value strategy leverage the long positions of the current bonds through pledge repurchase, and at the same time sell the corresponding futures contract. Hedge funds that adopt this strategy profit from the tiny spread between Treasury bonds and corresponding futures. In addition, since futures returns and changes in current bond returns are closely related, hedge funds can include small returns differences no matter what the market trend. This is an example of a "long-short strategy", in which a long position on an asset is hedged by a short position on a closely related asset.
can obtain high leverage relative to value investors, because they can obtain another $99 in new financing by pledging US $100 bonds, with an actual cost of only $1, so the leverage multiple is as high as 100 times, and even a small price difference can make high profits through high leverage.
Before the outbreak, the strategy achieved stable returns, showing that the strategy is very popular evidence that the futures short positions of leveraged funds continue to expand. However, after the volatility climbed, margin requirements also soared, especially in long-term US bond contracts. During this period, the liquidity of the goods market also deteriorated sharply, and the implicit rate of futures fell faster than the rate of return on the spot, resulting in losses calculated by relative value investors (selling futures, buying spot) at market price (market).
When hedge funds cannot meet margin requirements, their positions will be forced to be closed by traders and futures exchanges, pushing bond prices down, which in turn leads to the classic "margin spiral" - the roles between liquidity sharp drop, margin requirements increase, deleveraging, and price turmoil will strengthen each other.
Generally speaking, traders can alleviate market tensions by absorbing selling pressure and establishing some bond inventory. But traders' Treasury Inventories have also been saturated, especially since 2008, they need to absorb a large amount of bond issuance. Therefore, before the outbreak of the epidemic, so-called safe-haven assets such as U.S. bonds were essentially overheld. In addition, hedge funds have previously continuously increased their leverage position , resulting in the expansion of Treasury bond inventory of traders (who accepts Treasury bond pledges). Therefore, traders can no longer continue to absorb positions closed by investors in March, especially on long-term U.S. bond contracts, and then we can see that the 10-year U.S. bond yield once soared by more than 1% from around 0.4% in early March.
BIS believes that recent events suggest that governments may need to absorb sell-offs directly, rather than indirectly by lending to traders. This may also explain why in the current situation, the Fed's rapid purchase of securities from traders' inventory (total of approximately $670 billion) seems to stabilize the market more effectively than providing liquidity through a repurchase operation, which is relatively small in scale.
In addition, BIS also mentioned that the recent trends in the US Treasury market once again show that the high leverage obtained through cheap financing of securities positions may lead to the accumulation of negative convex positions. This directly increases the risk of endogenous feedback loops, as such positions will be quickly lifted in a nonlinear way as volatility increases. Therefore, market monitoring should go beyond the current situation and raise presumptive issues related to potential market pressures. To respond effectively, such comprehensive stress tests must assess potential space for forced sell-offs and feedback loops, especially during periods of calm where leverage continues to rise.
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