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
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.
- [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.
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