Mind the large gap between expected spot performance and expected total return. This of course reflects the fact that running USD shorts most often (not vs AUD and USD) implies a cost of carry. For EUR/USD, for example, that cost is 1.9% over one year, the largest cost in more than ten years. This largely reflects the short-rate differential – but not just that: large deviations from covered interest rate parity have become a quasi permanent feature. Two recent BIS papers1 analyse that deviation, which is most directly observed in the large levels of the cross-currency bases. A key finding from the BIS is that banks are less keen to lend in USD to non-US borrowers in periods when the USD is strong.

Also, USD strength tends to imply a fall in international reserves, hence a diminishing supply of USD in global markets. All this creates USD scarcity, which is a major concern given the need for non-US borrowers to roll very large amounts of USD-denominated debt. The outstanding of USDdenominated credit to the rest of the world has more than doubled over the past ten years to nearly $10tn (Graph 7a). EM countries and corporations in particular have been keen to borrow in USD ($3.2tn, Graph 7b). The rising rates and stronger USD will make it tougher to repay or roll that debt. This will tend to fan the search for USD, or scarcity.

Why does all that matter for currencies? Because such scarcity does impact spot rates. Graph 8, for example, shows the link between the 2y cross-currency basis USD-EUR and spot EUR/USD. This is not where our major concern is, given that ECB tapering in spring should keep that cross-currency basis in check (see our dedicated x-ccy section).

More generally, however, as the cost of hedging USD longs increases, the USD tends to be supported (Graph 10). We fear that cost will continue to increase in 2017 as the Fed raises rates and non-US borrowers struggle to roll their USD-denominated debt. This channel of transmission could make the USD strength self-sustained and eventually disruptive for global financial conditions.

Also, global USD strength tends to be associated with a rise in USD/CNY, as China targets the stability of the RMB basket (Graph 11). In late February 2016, the G20 sealed an (initially) secret deal to fight excessive USD strength – as it was becoming too disruptive indeed. We cannot exclude a repeat, yet we are concerned that the aggressive tone of a Trump administration, relative to both protectionism and isolationism, might make such a deal initially tougher to achieve, in which case we may see bouts of extreme USD strength into spring.

Source: efxnews.com