Is a shortage of dollar funding behind recent stockmarket weakness?

Roger Doig, Analyst, European & UK equities

The market selloff over the last six weeks has left many commentators scratching their heads. Banks look solvent, corporate credit looks robust outside some well flagged pockets of US high yield. The market signals fear, but what exactly is it afraid of? "Chinese stockmarkets are falling" is an observation, not an explanation.

One part of the explanation could be a shortage of dollar funding, which is particularly pronounced in Asia. The falling oil price has been a key driver of this, as oil-producing countries see lower surplus US dollar balances. However, there is also a structural reason for the shortage, which is the result of US banks and money market funds changing their cash management processes in response to Basel III liquidity rules and SEC rules on money market funds. Where previously there was a degree of fungibility (i.e. mutual substitution) between US onshore dollars and the Eurodollar (offshore) market, facilitated by prime funds[1] lending to offshore banks, the new rules are in the course of shifting this liquidity to US banks, whose hurdle rate for overseas lending is rather higher.

The specific changes are as follows. Firstly, US banks are incentivised under Basel III liquidity rules to seek retail deposits and ditch commercial non-operating deposits (essentially surplus corporate cash) which have the highest liquidity backing requirements and thus the lowest returns. JP Morgan reduced its non-operating balances by $200 billion in Q4 2015, for example. These funds will move to money market funds.

Secondly, institutional prime funds (which invest in commercial paper and certificates of deposit) have to float their net asset values and implement liquidity gates and fees under SEC rules[2]. Government-only money funds do not face these restrictions. However, these have to invest in cash and Treasuries. So, while money is coming into institutional money market funds, it will flow into government-only rather than prime funds. Meanwhile on the retail side, banks will aim to grow deposits, which will be more attractive than money funds because the latter will have gates.

In short, by the end of this year, $1 trillion of prime fund money will have shifted to government-only funds, with US Global Systemically Important Banks (GSIBs) either shrinking their balance sheets by getting rid of non-operating deposits, or replacing some with retail deposits, but being structurally less willing than prime funds to lend offshore.

Now, any institution that has been lending in US dollars offshore will see its cost of funding increase. And there has been a lot of offshore (Eurodollar) lending.

Add to the mix the fall in the oil price, which reduces the availability of offshore dollars, and there is a double whammy. At this point banks either shrink the asset side of the balance sheet, or pay up for liquidity. This is what happened in the eurozone in 2011 before the Long Term Refinancing Operations or in the offshore US dollar market in 2009. Central bank swap lines with the Federal Reserve (Fed) can provide emergency overnight dollar funding if required, but that is not a long-term funding strategy.

There are two conclusions we can draw from this: either one can expect international US dollar assets to shift down to a different valuation equilibrium - which we assume is the process of happening, and which will lead to a potentially lengthy period of volatility - or one can hope for the market to "come to its senses", which is effectively a hope for a fourth round of QE from the Fed.

[1] A prime fund buys high-grade corporate loans from banks and aims for returns in line with the prime rate i.e. the rate charged by banks on loans to their most credit-worthy customers.

[2] A floating net asset value allows the daily share prices of these funds to fluctuate along with changes in the market-based value of fund assets. Liquidity fees and redemption gates are for use during times of market stress to guard against runs.

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