Ad Hoc Commentary: Dodd-Frank rollbacks to fix monetary transmission via FX Swap

Monetary policy transmission is broken today as measured by the FX swap implied rate of US dollar versus Interest on Excess Reserves rate. Those who are still looking at Libor versus Fed Funds rate are forgetting that big players seldom trade unsecured post-Lehman. Unsecured rates are dying and thus the push to replace Libor with secured rates: The demise of unsecured rates is also the reason why the Fed hike rates via IOER and RRP today, as opposed to only targeting the unsecured, and largely soporific, Fed Funds market.

If you take a look at 1 week FX swap implied rates for EURUSD (EURI1W Curncy) and USDJPY (JPYI1w Curncy), you will notice quarterly negative dips that essentially means that foreign banks are scrambling for US dollars quarterly. If you overlaid them with utilization of central bank FX swap lines by ECB (FESAEUCB Index) and BoJ (FESABKJP Index), you will notice that foreign central banks tap the central bank swap lines every quarter end to ease quarterly shortage of US dollars.

These dips are effectively US dollar interest rate hikes without the Fed, or in other words a broken monetary policy transmission. Two key piece of regulation stand in the way of a proper monetary policy transmission. First is the supplementary leverage ratio (SLR). Second is the Volcker rule.

First, we look at the SLR. The main culprits are European banks. Europeans report SLR compliance using point-in-time-quarter-end data due to the European Leverage Ratio Delegated Act. This means European banks switch off FX swap arbitrage every quarter-end in preparation for regulatory reporting. This quarter-end window dressing leads to the quarterly spikes. The quarterly spikes are offshore US interest rates hikes without the Fed.

Second, the Volcker rule makes it difficult for US banks to take advantage of the lucrative US interest rates available on the FX swap market. Volcker disallow speculative books in FX forwards – thus US banks needs to find intermediaries to borrow deposits and lend it on to them via FX swaps. With the intermediary running the deposit/FX swap speculative book, US banks can then run FX swap/FX swap matched books (which are allowed under Volcker rule) to take advantage of the deviations from covered interest parity in the FX swap market.

A combination of SLR and Volcker rule rollbacks will thus ensure a better monetary policy transmission. This is important given the Fed is on a hiking cycle, reserves are being drained from the system as the Fed reduce the size of its balance sheet, and offshore US liquidity is being drained by tax reforms for US corporate. So, it is not surprising that regulators are proposing that:

  1. SLR is to be relaxed for regional banks (by dropping them off the SIFI list),
  2. SLR is to be diluted for custodian banks (by removing the return on equity dilution effect of reserves),
  3. Volcker rule is to be repealed for small banks.

At the end of the day, it’s price versus quantity. If the Fed wants to target price (i.e. interest rates), then it needs to provide quantities (remove balance sheet constraints) so that the market can clear at the new target price. The recent efforts to repeal parts of crisis era regulations is good for monetary policy transmission. It remains to be seen if the regulatory rollbacks are sufficient to put an end to quarter end deviations of as much as 700bps (for 1w EURUSD in Dec 2017) and 1ooobps (for 1w USDJPY in Dec 2017) from covered interest parity. Ultimately, it will be a play of how much quantity is being drained by the central bank and corporate sector versus how much quantity is being pumped back into the system by less regulatory constrained financial intermediaries.

Good luck in the markets.