Over the past week we have shown on several occasions that there once again appears to be a sharp, sudden dollar-funding liquidity strain in global markets, manifesting itself in a dramatic widening in FX basis swaps, which – in this particular case – has flowed through in the forward discount for USDJPY spiking from around 0.04 yen to around 0.23 yen overnight. As Bloomberg speculated, this discount for buying yen at future dates widened sharply as non-U.S. banks, which typically buy dollars now with sell-back contracts at a future date, scrambled to procure greenbacks for the year-end.
However, as Deutsche Bank’s Masao Muraki explains, this particular dollar funding shortage is more than just the traditional year-end window dressing or some secret bank funding panic.
Instead, the DB strategist observes that the USD funding costs for Japanese insurers and banks to invest in US Treasuries – which have surged reaching a post-financial-crisis high of 2.35% on 15 Dec – are determined by three things, namely (1) the difference in US and Japanese risk-free rates (OIS), (2) the difference in US and Japanese interbank risk premiums (Libor-OIS), and (3) basis swaps, which illustrate the imbalance in currency-hedged US and Japanese investments.
In this particular case, widening of (1) as a result of Fed rate hikes and tightening of dollar funding conditions inside the US (2) and outside the US (3) have occurred simultaneously. This is shown in the chart below.
What is causing this? Unlike on previous occasions when dollar funding costs blew out due to concerns over the credit and viability of the Japanese and European banks, this time the Fed’s rate hikes could be spurring outflows from the US, European, and Japanese banks’ deposits inside the US. Absent indicators to the contrary, this appears to be the correct explanation since it’s not just Yen funding costs that are soaring. In fact, at present EUR/USD basis swaps are widening more than USD/JPY basis swaps.
According to Deutsche, it is possible that an increase in hedged US investments by Europeans could be indirectly affecting Japan, and that market participants could also be conscious of the risk that the repatriation tax system could spur a massive flow-back into the US, of funds held overseas by US companies
In fact, one can draw one particularly troubling conclusion: the sharp basis swap moves appear to have been catalyzed by the recently passed Trump tax reform.
- Corporate tax reform in the US
The United States House of Representatives and Senate recently passed a tax reform bill that lowers the corporate tax rate from 35% to 21% starting 2018. Lowering corporate taxes would likely accelerate the pace of Fed rate hikes, which could trigger a shift from dollar deposits to Government MMFs. Revisions to interest tax deductions would encourage companies to repay corporate bonds and could spur a decrease in dollar deposits (however, demand to bank loan could also weaken).
- Repatriation tax system
The tax bill also includes the abolishment of taxation (currently 35%) on dividend payments from overseas subsidiaries. However, overseas subsidiaries’ retained earnings would be subject to a one-time tax. It is expected that this repatriation tax system would result in reserves held overseas by US companies (we estimate 90% are USD-denominated) flowing back into the US. This could create tighter conditions for USD financing outside the US.
Which leads to a bizarre outcome, that while the GOP tax reform may benefit corporate America, it appears set to punish America itself as buyers of US Treasurys suddenly require far greater yields to offset the surge in funding costs!
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Whatever the cause behind these sharp funding shortages, one thing is clear – dollar funding costs (FX hedging costs) for both Japanese and European insurers and banks to invest in US Treasuries are surging (with Japanese buyers and reached a post-financial-crisis high of 2.35% on 15 Dec. And in terms of practical implications for the treasury market this means that, all else equal, marginal demand for US paper is about to plunge for one simple reason: the FX-hedged yields on US Treasurys have plunged to (negative) levels never seen before (unless of course foreign investors buy US Treasurys unhedged).
To demonstrate this point, the chart below from Deutsche Bank shows the yields on currency-hedged US Treasuries from the perspective of Japanese investors. Japanese financial institutions tend to use 3-month FX forwards when they invest in hedged foreign bonds. Annualized hedge costs have recently risen to 2.33%, which means that investments in 10y US Treasuries result in virtually no yield. Furthermore, yields from investment in shorter than 10y US Treasuries would be less than JGBs and result in negative spreads. This means that unless funding costs slide, Japanese buyers will simple pick JGBs over TSYs, eliminating one of the biggest sources of Treasury demand in receng years.
There is another consideration: as Deutsche Bank notes, whenever it is time to roll over a hedge, financial institutions need to decide whether to (A) sell US Treasuries or (B) hold them as unhedged foreign bonds. Engaging in (B) on a large scale would be difficult unless the institution’s outlook calls for yen depreciation. After implementing (A), institutions should then choose to invest in high-yielding US MBS (high interest rate risk), medium- to low-rated corporate bonds (high credit risk), European and other sovereign bonds, or to reinvest in JGBs.
Moving away from Japan, and looking at Europe one finds an even more dramatic slide in hedged TSY yields, which net of hedge costs have plunged to -0.6%, by far the lowest – and most negative – on record, something we highlighted yesterday in “There’s Never Been A Worse Time For A European Investor To Buy US Treasuries” .
The conclusion is that as a result of the recent surge in funding costs, seemingly in response to the nuances of Trump tax reform as explained above, suddenly buying US Treasurys is no longer an economic option for virtually all foreign buyers! Needless to say, something will need to change because if funding costs stay where they are, yields across the curve will have to jump for US Treasurys to once again be an attractive purchase for foreign buyers, which as a reminder comprise the majority of TSY buyers in recent years.
What is the outlook? Some parting thoughts from Deutsche, which writes that according to the chart below, fundings costs will likely continue widening as the Fed raises interest rates.
DB then also warns that the repatriation tax system that was just passed into law, coupled with ongoing Fed rate hikes, will indirectly result in the widening of dollar funding conditions in and outside of the US. And the punchline: if these indeed continue to widen, and US long-term interest rates stay at a low level, “this would restrict investments in US Treasuries by Japanese financial institutions relying on short-term dollar funding.” This could then lead to a sharp move higher in US yields – and rates- as the US finds it needs an aggressive increase in foreign demand to finance the widest US budget deficit in years.
In other words, by pounding the table on – and recently passing – tax reform, Donald Trump appears to have sown the seeds of the equity market’s own destruction, because remember that the one thing that can bring the house of manipulated cards down faster than you can say covfefe, not to mention burst the equity bubble, is a sharp move higher in long-term yields, rates, and ultimately – inflation.