Global dollar crunch appears over as central banks rely less on Fed backstop

Data from the Fed on Thursday showed its peer banks around the world this week tapped it for the fewest dollars in nearly three months, and it was the main factor driving a surprise reduction in the Fed’s $7 trillion balance sheet - the first since February and the largest since the waning days of the financial crisis more than a decade ago.

The balance of the Fed’s foreign exchange swaps with other central banks dropped by $92 billion as of Wednesday to $352.5 billion from $444.5 billion a week earlier. The total amount outstanding in the swap lines, designed to ease a surge in demand for U.S. currency in the participating banks’ jurisdictions during the early weeks of the crisis, was the lowest since early April.

Coupled with other indications of slackening demand for the Fed’s bevy of emergency liquidity facilities, the reduction in currency swap line usage is for many analysts a sign that global financial markets are returning to near-normal after being upended by the coronavirus outbreak in February and March.

In that period, stocks plunged into bear markets at record speed, risk premiums in credit markets mushroomed and demand for greenbacks overseas well outstripped supply, making the dollar unbearably pricey for foreign governments and companies with dollar-denominated liabilities. The Fed acted swiftly to try to restore order, and along with facilities aimed at U.S. markets, expanded currency swap line agreements to nine central banks in addition to the five with which it has had standing agreements.

“Given the restored health of (dollar) funding markets, and the fact that the swap lines will still be there serving as a backstop, we expect this handoff from central bank liquidity to the market to be relatively uneventful,” said John Roberts, U.S. rates strategy analyst at NatWest Markets.

But the drop-off from here may be swift.

“We expect a more rapid decline over the coming months as the majority of the swaps will roll off,” Citigroup economists wrote in a note to clients on Friday.

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