What to see from FED's repo facility?

The FED is launching new facilities designed to provide liquidity to big Wall Street banks and foreign institutions like central banks, which could help ensure market stability at times of stress.

In the above action, the Fed took another step in trying to secure an adequate supply of dollars to international markets during times of stress. It could make stop USD rising when adverse shocks occur. But they might be more muted than in the past and that might give investors more confidence in holding riskier currencies.

USD rises and falls over time and we can’t always be sure why. This being said, there are certain periods when the reasons for the moves in USD seem very clear. One such time is during periods of significant stress, like the global financial crisis of 2008 or, more recently, the outbreak of Covid-19. In these periods, the centrality of USD to the global financial system means a sharp rise in the demand for USD. But if the extra US dollars can’t be supplied, a shortage develops and is reflected in a sharp move in currency basis spreads and, of course, a significant increase in the value of USD.

These risks of a dramatic surge in USD arguably give the greenback something of a premium over most other currencies, and particularly those thought to be of higher risk, like emerging market currencies. This is one aspect of what’s called the dollar’s exorbitant privilege. But what if the US authorities could seek to mitigate this privilege, if only slightly, by ensuring that dollars don’t run short during crisis events? This is what the Fed has been trying to do for some time with actions such as the creation of central bank FX swaps with other significant central banks. A more recent addition was the announcement last March of a temporary repo facility for foreign central banks and other official institutions. Under this facility, central banks could exchange treasuries for cash on a temporary repo basis.

At the recent meeting, Fed meeting members agreed to make this facility permanent subject to an individual country limit  of USD60bn. Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks this is an important step in helping to ease the dollar shortage issue. Not all might agree. For a start, the repos are only given to those that hold their treasuries in custody at the NY Fed. Secondly, the move, like the temporary facility is biased to help those foreign central banks that hold the most treasuries and, in most cases, those that hold the most treasuries, like the Bank of Japan, are least likely to need dollars quickly. This is because dollar debtors in Japan should still be able to access dollars quickly through the financial markets, whereas this might be harder for an average African or Latin American dollar debtor as financial market liquidity can dry up in a crisis. But, in spite of these sorts of caveats, we do think that permanent repos, alongside central bank swaps from the Fed, help alleviate the upside pressure on the dollar during times of stress.

For those that might want to invest in riskier countries, these facilities should act as a sort of insurance policy. What’s more, there is evidence to suggest that these facilities are already helping. The dollar’s surge against emerging market currencies lasted much longer during the global financial crisis, when these Fed facilities were much weaker than they are now, than the Covid shock of the past 18 months. Of course, there could have been other reasons why it took EM currencies around three years to recoup the GFC losses and only one year to recapture the ground lost to the dollar during the pandemic. However, Mr. Mr. Steve Barrow suspects that the provision of bigger and wider dollar-supplying facilities by the Federal Reserve was a key ingredient.

As it was said at the top, facilities such as this won’t stop the dollar rising against EM currencies in times of extreme global stress. But the degree might be more limit ed and the longevity of the disturbance reduced and, for that reason investors might just feel a bit more confident about holding emerging market currencies.