Are international swap lines to blame for the dollar's doldrums?
With the gold price remaining firm in the face of a hawkish Fed and rising real interest rates, the yellow metal continues to benefit from the USD Index's recent pullback. Moreover, with the Federal Reserve's swap lines allowing international central banks to access U.S. dollars without having to hit the bid in the open market, concern has arisen that the gambit could depress the greenback's value.
However, while these emergency channels are put in place to avoid a liquidity crisis, please remember that they have an immaterial impact on the USD Index's value.
For example, the Fed established new emergency swap lines on Mar. 19, 2020, during the height of the COVID-19 crisis. The press release read:
“The Federal Reserve on Thursday announced the establishment of temporary U.S. dollar liquidity arrangements (swap lines) with the Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank (Norway), the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank (Sweden).
“These facilities, like those already established between the Federal Reserve and other central banks, are designed to help lessen strains in global U.S. dollar funding markets.”
Please see below:
Source: U.S. Fed
But, the market impact of the liquidity arrangements was much more semblance than substance.
Please see below:
To explain, the red line above tracks the USD Index, while the green line above tracks the inverted (down means up) S&P 500 as the pandemic unfolded in March 2020. Coincidentally, the USD Index peaked on Mar. 19 (closing high), so one could surmise that the swap lines had a profound impact.
Conversely, the important development was that the S&P 500 bottomed on Mar. 23, and the optimism helped uplift risk assets at the expense of the USD Index.
If you analyze the relationship on the left side of the chart, you can see that as the S&P 500 plunged, the USD Index soared. Then, as the S&P 500 began its QE-induced rally (green line falling), the dollar basket declined and eventually sunk below 90 in the months that followed.
Also noteworthy, if you focus your attention on the vertical gray line near the right side of the chart, you can see that the USD Index remained relatively range-bound until May 25. As a result, the Fed’s swap lines didn’t have much impact on the dollar’s performance.
For more insight, it’s important to understand how the financial markets work. For example, if the ECB wants to exchange dollars for euros, a swap line could prevent upward pressure on the dollar. But, the futures market doesn’t follow this script.
While the USD Index is a basket of six currency pairs that each have their own fundamental and technical drivers, when traders buy and sell USD Index futures, the contract is essentially its own instrument.
Therefore, if a market catalyst (hawkish Fed, recession, S&P 500 sell-off, etc.) sparks a bid for USD Index futures, the momentum uplifts the underlying currency pairs. This occurs because arbitragers can earn a risk-free return when the USD Index futures contract trades at a premium/discount to the weighted basket of underlying FX pairs.
In a nutshell: if the front-month USD Index futures contract trades at 110, while a weighted basket of the six currency pairs trades at an index value of 108, arbitragers can buy the six pairs and sell the USD Index futures contract and earn a riskless profit; and when these opportunities occur, arbitragers will repeat the trade until the two baskets converge.
An easier way to think about it is to consider the S&P 500: the index is comprised of 500 companies that also have their own fundamental and technical drivers. In contrast, if the S&P 500 futures contract is down by say 1% at the open, the spot market (daily cash trade) will decline and converge with the futures price because arbitragers will sell an underlying basket of stocks (like the SPY ETF) and buy the futures contract until the risk-free profit is eliminated.
Remember, the arbitrage relationship between the spot and futures markets keeps asset prices in balance. Otherwise, traders could make enormous sums of money with no risk.
The key point is that the futures market will have more impact on the USD Index’s performance than the Fed’s swap lines. If market participants develop a fundamental, technical or momentum case to own the dollar basket, their behavior will overpower other factors.
In addition, please note that a stronger U.S. dollar aids the Fed’s inflation fight. When the greenback rises, it reduces the FX-adjusted cost of foreign imports, which helps decrease domestic output inflation. In contrast, when the greenback falls, it increases the FX-adjusted cost of foreign imports and incentivizes U.S. companies to raise their output prices to protect their profit margins. As such, it’s in the Fed’s best interest to increase the USD Index’s value.
Overall, the gold price continues to outperform the S&P 500, and the USD Index’s recent consolidation has boosted investors’ optimism. However, a major shift in sentiment should occur sooner rather than later. To explain, we wrote on Dec. 19:
The U.S. 10-Year real yield has risen materially in December. Previously, the metric declined from its 2022 peak of 1.74% on Nov. 3 to a low of 1.08% on Dec. 2. Coincidently, the PMs rallied during this period as the USD Index came under pressure. In contrast, the metric ended the Dec. 16 session at 1.35%, which marks a 27 basis point increase in two weeks.
Furthermore, that momentum continued on Dec. 19, as the U.S. 10-Year real yield closed at 1.42%. So, while the S&P 500 has noticed, the PMs are ignoring the ominous development at their own peril.
Alex Demolitor
Precious Metals Strategist