Has the offshore dollar market in terms of dollar financing and currency hedging gotten so big that it can dictate Federal Reserve monetary policy including the expected short-term interest rate cut by the Fed at its July 2019 open market committee meeting? In other words, has the Federal Reserve lost its ability to conduct monetary policy and control interest rates as it sees fit and is now in search of other tools?
In this episode you’ll learn:
- Why the Federal Reserve is puzzled by how U.S. interest rates are behaving.
- How the large but opaque offshore dollar lending and currency hedging market could be strengthening the dollar, slowing the global economy and pushing down interest rates.
- What is leading to a global dollar shortage.
- Why the Federal Reserve is researching other policy tools.
- What investors can do to protect against uncertainty regarding the dollar
Show Notes
Dollar shortage *alert* (plus global trade *alert*) by Izabella Kaminska—Financial Times
See and Hear the Ruffed Grouse’s Haunting Air Drumming—Audubon
The Drumming of the Ruffed Grouse—BirdNote
Money For the Rest of Us Episode 134: It’s Just Money
TIP251: MACRO THEMES – SUMMER 2019 W/ LUKE GROMEN—We Study Billionaires
All you want to do is connect the dots, right? by Luke Gromen—Forest For the Trees LLC
Monetary policy challenges posed by global liquidity by Hyun Song Shin–BIS
Financial market indicators of global liquidity risks by Jeffrey P. Snider—Alhambra Investments
Interest Rate on Excess Reserves-Effective Federal Funds Rate— Federal Reserve Bank of St. Louis
The Joke Finally Broke By Jeffrey P. Snider—Alhambra Investments
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Episode Summary
Falling interest rates are the suspected outcome of the July 30-31, 2019 Federal Reserve Committee meeting, and doubts are rising concerning the ability of the Federal Reserve to control interest rates on reserves and the effective Fed Funds rate. Up to this point, the Federal Reserve has sought to raise interest rates so that the interest rate paid on the reserves is higher than the target Fed Funds Rate that banks charge to lend to each other overnight. This past May, however, saw the Fed Funds Rate rise higher than the interest rate on reserves. In this episode, David shares the theories of why falling interest rates may pose problems for the future of the U.S. dollar and what listeners can do to cushion their currency holdings and portfolios against a slowing global economy.
The offshore U.S. dollar is influencing the Federal Reserve
Many are blaming the inability of the Federal Reserve to control the price of money on the “global dollar shortage.” The activity of the U.S. dollar—while it can be monitored within the U.S.—is more difficult for the Federal Reserve to track when it belongs to cash-holders, banks, and businesses outside of the U.S. The dollar is used as a hedging tool as well as a major currency for issuing debt outside of the U.S. The behavior of that offshore dollar market has begun to determine the behavior of the U.S. dollar on U.S. soil.
One of the most influential aspects of offshore transactions is the FX swap, which is where “two parties exchange two currencies and commit the reversed exchange within a year.” The FX swap is extremely common—estimated up to 10.7 trillion dollars worth of activity. Acting as a hedging tool, it generates debt—none of which appears within the Federal Reserve’s documentation. Not only that, but there is an estimated 10.7 trillion dollars in documented offshore debt and 10 trillion dollars in undocumented, offshore short-term debt. Because of this, there is a huge amount of money that is unaccounted for. The Federal Reserve is being steered by the unseen force of offshore U.S. dollar movement.
The global supply chain is falling short of the dollars they need
The use of the U.S. dollar for hedging and borrowing is steadily growing among foreign banks and businesses, and they have to service the growing debt in U.S. dollars—creating a potential shortage. Because of this shortage, banks around the globe are less willing to lend in dollars. There is essentially a liquidity fear within the global U.S. dollar market, which causes contraction—leading to a demand for what banks consider more “pristine” collateral. This unwillingness to lend while also demanding more collateral drives interest rates down. If banks aren’t willing to lend as much, the amount of active U.S. dollars shrinks, creating an even greater demand and pushing up the value of the dollar—all without the Federal Reserve lifting a finger on the price of money.
Interest rates and the global economy form a complicated matrix
The demand for and pressure put upon the dollar in the global economy has caused a lot of unprecedented change in the way the Federal Reserve can function. The root causes can be difficult to find, understand, or track—creating a complicated matrix of U.S. dollar behavior and value throughout the world.
The reach of the U.S. dollar has become so extensive that there is no true way of controlling it. As the U.S. debt continues to rise, there will be even more demand on reserves—on the dollar. One of the scary parts is that the dollar—a fiat currency—isn’t backed by anything.
Mitigating fear of falling interest rates by diversifying currency holdings
What do investors do about the inability of the Federal Reserve to control the price of money, interest rates, or the Federal Funds rate? Will falling interest rates prove a disastrous problem as the global economy slows? David encourages listeners to continue to learn about the issue—to educate themselves while also taking active steps to diversify their currency holdings. Own some gold, real estate, and cryptocurrency. Expand your portfolio to include international stocks. The U.S. dollar may be the currency of the highest demand, but it isn’t the only one you should be leaning on.
Episode Chronology
- [0:20] The suspected outcome of the Federal Reserve Committee Meeting on July 30th and 31st.
- [3:04] Is the Federal Reserve’s inconsistency, in this case, something to fear?
- [6:31] The influence of offshore U.S. dollars on the Federal Reserve.
- [9:10] The issue of undocumented offshore dollar-denominated debt.
- [12:06] The ramifications of the inability of the global supply chain to access the dollars they need.
- [15:21] Banks are less willing to lend dollars while also demanding more “pristine” collateral.
- [18:36] The complexity of the global U.S. dollar matrix.
- [21:06] Steps to take to cushion your portfolio against any ramifications of a lower Federal Reserve interest rate.
Related Episodes
22: Will Interest Rates Ever Increase?
52: Why Are Interest Rates So Low, Even Negative In Some Places
82: What Assets Return When The Fed Raises Rates
122: Why Negative Interest Rates Are Dangerous
133: Interest Rates Are Rising. Four Things You Can Do
255: With Interest Rates Falling, Why Do You Own Bonds?
264: What Happens If U.S. Interest Rates Turn Negative?
300: Ray Dalio and the Changing World Order
Transcript
Welcome to the Money for the Rest of Us, this is a personal finance show on money, how it works, how it invest it, and how to live without worrying about. I’m your host David Stein. Today is episode 260. It’s titled: “Is this the reason interest rates are falling and the global economy is slowing?”
Cutting interest rates
On Tuesday and Wednesday, July 3oth and 31st, 2019, the Federal Reserve Open Market Committee is meeting. And all indications are: they will cut their policy rate, the federal funds target rate, as well as the interest rate that the Federal Reserve pays on the reserves that banks hold at the Central Bank.
The Federal Reserve has been on a process of raising its policy rate, it was close to 0 back in 2015. Now it’s at 2.5% and they’re suggesting it could be an insurance cut to help the economy, the global economy, which appears to be slowing partially due to trade, but more importantly and potentially due to an even more serious concern that I talked about way back in episode 134. It was a global dollar shortage.
Global dollar shortage and Fed Funds Rates
In that episode, I quoted Izabella Kaminska. She writes for the Financial Times Alphaville blog. She said, “Global dollar shortage stands to become the most significant destabilizing force in recent times and the most unanticipated global tail risk.”
Now that seems like kind of an arcane topic, and it’s somewhat complex, but it’s important because something happened in May that has not happened before. The Federal Reserve pays interest on these reserves that banks have and generally speaking, they have set that interest rate above what’s known as the Effective Fed Funds Rate. And so banks are getting this interest, the Fed Funds Rate is the rate banks charge each other to lend overnight. Because they had so many reserves, often that wasn’t necessary.
In an orderly, monetary regime, the Federal Reserve sets the rates it wants. It has the target for the Effective Funds Rate and it has a target for the interest on these excess reserves. And it’s desire was that the rate on the excess reserves would be higher than that Effective Funds Rate. Except, beginning in March and continuing today, the Federal Funds Rate is yielding—it’s higher than that rate on those reserves held at the Central Bank.
Why does it even matter? Does it matter? Jeff Snider, he’s the head of research at Alhambra Capital, says it matters because “The Federal Reserve chose specifically to keep federal funds as its primary communication tool. Therefore it means a great in the mainstream end of things. It’s the one thing that Federal Open Market Committee is supposed to be able to control above everything else. That’s what they said when sticking with it. And thus if you don’t get the things you know right, the little things, what chance for getting the bigger things right. Everything that actually does matter. Zero chance.”
Is the Federal Reserve losing its ability to price money to set its policy rate? If its goal was to keep the Federal Funds, the Effective Fed Funds Rate below the interest rate on what it pays on reserves, and yet the Fed Funds Rate is actually higher than that. Why would it be higher than that? We’re going to look at that in this episode. Is this something we should really fear, or not?
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