How will the US dollar move following the banking crisis?

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One key issue for policymakers and investors arising from recent banking strains is whether these will morph into more general funding and liquidity tensions. If they don’t, and pressures remain local to the banks that have been involved, such as Silicon Valley Bank and Credit Suisse, then there’s little for policymakers to fear. But clearly if financial strains increase more widely, on a par with the 2008/09 global financial crisis, things could be a lot different. So far, it seems that we’re on the more stable path but, as we know, a jump to the more disruptive and volatile path could happen very easily.

If we were to undertake a variance decomposition exercise to try to determine how much of the recent stress in the financial market is down to different factors, we’d find that much of the recent variance has been created by things like surging volatility in asset prices. What we would not find is that a large part of the variance has been created by funding stress. That’s good news. Asset prices are volatile and while periods of very significant volatility can cause problems for holders, the real chaos ensues when the funding of these positions becomes very expensive or, worse still, non-existent.

During the turbulence of recent years with the pandemic in 2020 and, more recently, Russia’s attempted invasion of Ukraine, we’ve found asset prices to be volatile but funding stress has either been contained, or else temporary. Of course, the difference today is that the pressure has fallen on the banks who are clearly among the major suppliers of funding. Could this mean that the current situation is far more dangerous than anything we’ve seen in recent years when it comes to a funding squeeze, global contagion and all those other nasty things that happen when a financial crisis ensues?

A variance decomposition of financial stress is observable of sorts from the Office of Financial Responsibility (OFR) which is a department within the US Treasury. Its financial stress index breaks stress into five main components: credit, equity valuation, safe assets, funding and volatility. A picture of the stress index reveals that the stress we’ve seen this year is mostly a function of things like volatility and equity valuation, not funding. This funding measure comprises market-based prices such as libor-OIS spreads, swap spreads and cross-currency basis spreads and it still lies below the zero line that denotes that stress levels are below “normal”.

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The last time funding strains emerged, with figures well above zero, was in the first quarter of 2020 when the pandemic was wreaking its economic and financial market havoc. Back then central banks supplied liquidity to ease the strains and the trick seemed to work as, indeed it has so far during this recent bout of banking stress.

In Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, another key indicator on this front is that dollar demand at the daily dollar auctions by major central banks has not accelerated from the levels we saw before the bank strains emerged. This is one reason why the dollar has not rallied during this period of bank stress. Instead, it rather seems as if the market has been able to treat the tensions as a negative for the dollar, given that most problems seem to lie in the US, rather than a positive factor because it creates dollar shortages as financial firms start to contract their lending and other forms of financial intermediation.

“Should perceptions change, and funding strains tighten financial conditions, the dollar will likely rise. But this is not our base case. This being said, we are not suggesting that measures of global financial stress will ease significantly. Instead, they are likely to stay high but do so because of the more benign factors such as asset price volatility rather than the more insidious problems associated with tighter funding conditions”, said Mr. Steve Barrow.