- The introduction of the BTFP may have changed the level playing field for financial institutions since not all financial entities are able to access it.
- From a macroeconomic perspective, this could potentially herald the next phase of deglobalization, during which the weaponization of USD liquidity may become a reality.
- In our view, talks of rapid de-dollarization could be premature—alternatives may emerge, but USD dominance is likely to remain for the foreseeable future.
A question of fairness: hidden advantages
Wall Street has presented endless takes on the Bank Term Funding Program (BTFP), but many have glossed over a critical detail: The program doesn’t apply to everyone.
Under the BTFP, entities such as banks and credit unions that are regulated by the Federal Deposit Insurance Corporation can pledge their holdings of U.S. Treasuries (UST) and mortgage-backed securities (among others) as collateral at the U.S. Federal Reserve (Fed) in exchange for U.S. dollar (USD) liquidity.
These instruments will be valued at par and could be used for loans drawn from the Fed’s discount window. The program will also be open to the U.S. branches or agencies of foreign banks that are currently able to access the Fed’s discount window. So far, straightforward.
Bank Term Funding Program: how it works
Source: Manulife Investment Management, as of April 5, 2023. For illustrative purposes only. Fed refers to the U.S. Federal Reserve.
However, it’s also fair to say that entities that are able to access the BTFP have an advantage over those that don’t; in other words, a list of potential winners and losers has been drawn. Essentially, those able to tap into the program are able to ignore the mark-to-market losses they’ve incurred on their UST holdings—a direct outcome of the surge in rates over the past year.
Conversely, mark-to-market losses incurred by their less fortunate peers will continue to be reflected on their accounts and crystalized on their profit and loss statements should they end up selling their holdings at market prices. This group will likely comprise foreign financial institutions and global central banks whose balance sheets typically feature a significant chunk of UST.
In our view, this poses important philosophical questions that can have important macroeconomic implications. From a markets-functioning perspective:
- It could potentially amplify the USD shortage in the rest of the world. A USD shortage in this context isn’t the same as shorting an asset expecting depreciation; rather, it refers to a funding gap, a mismatch between USD assets and liabilities.
- Financial conditions in the United States could loosen even as they tighten in the rest of the world. Theoretically, this would mean U.S. economic and market outperformance versus the rest of the world in the current environment of stagnating growth.
- Capital flows into the United States could rise as investors seeking better liquidity and economic growth conditions flock into the market, particularly through entities that are able to access the BTFP.
Taking a 30,000-foot view, the following questions should be considered as well:
- How might this affect the USD’s appeal to global investors and its role as a global reserve currency?
- How might this affect the UST’s appeal as a liquid store of value from an international perspective?
- Will this prompt a different form of protectionism?
These questions aren’t new—they’ve been percolating for decades—and answers aren’t likely to be available anytime soon; however, the frequency at which these questions are raised by prominent thinkers has increased in recent years.
Given that these issues are ultimately rooted in the political economy, concerns about potential reaction/retaliation are just as relevant. Europe’s misgivings about the Biden administration’s green deal, an initiative that appears to have the effect of making the Continent much less appealing to green tech innovators relative to the United States, is one good example.
"In our view, we could be looking at the weaponization of USD liquidity in which bifurcated global capital markets may become a reality."
The next phase of deglobalization
It can be argued that the introduction of the BTFP could potentially herald the next phase of deglobalization: In our view, we could be looking at the weaponization of USD liquidity in which bifurcated global capital markets may become a reality.
Embedded within that is the idea of onshoring and friend-shoring USD liquidity. This shouldn’t be totally surprising after what’s transpired recently, where commodities, food-related items, and semiconductor technology have more or less been weaponized at various points in the last 18 months.
This was the direction of travel we flagged previously: If this were indeed the case, it reaffirms our strategic policy and investment views. From a policy perspective, governments will be more motivated to adopt policies to ensure that large government deficits are absorbed by even larger domestic private surpluses and external surpluses. Put differently, the domestic supply of goods and services must exceed demand.
A return to protectionism?
In our view, such policies would be highly protectionist in nature and could include the promotion of domestic infrastructure development programs using domestic capital and labor. They could also take the form of heavily subsidized research and development programs to help the domestic industry move up the global value chains; in addition, tariffs/import controls and export subsidies could be introduced or reinstated to protect domestic industry and corporate profitability.
Similarly, policymakers could take aim at encouraging domestic consumption (by boosting higher household incomes) and/or imposing capital controls to keep extra liquidity from leaking overseas and limiting currency devaluation.
Global trade openness: progressing in reverse?Sum of exports and imports expressed as a share of GDP (%)
In such a scenario, central banks would, by default, lean toward monetizing government debt. Economies with limited policy space to monetize debt or those that are unable to adopt protectionist policies would most likely join currency and trading blocs that do have space to do so. There are many historical precedents for just this sort of global fragmentation, particularly during the period between the two world wars, commonly known as in the interwar era (1915–1945), which is defined by international conflicts, the abandonment of the gold standard, and the rise of protectionism.
Implications: where does that leave us?
Over the medium term, assuming that we remain on the current trajectory and no other major disruptive events emerge, we expect the government’s role in a country’s economy to increase. In essence, governments will have more influence in terms of resource allocation and, by extension, the direction in which their countries are headed. Naturally, the extent of their involvement will vary greatly from country to country, and the mechanisms involved should also differ significantly.
During this time, we believe central banks will come under increasing pressure to fund government spending by increasing the amount of money supply that’s circulating in the financial system (i.e., printing money). This is likely to be accompanied by a rise in private sector deleveraging, reshoring, and reindustrialization efforts in developed markets and a ramp-up in industrialization initiatives in emerging markets.
Heightened geopolitical tension is expected to feature strongly in this setting. It’s also a period during which we could see the emergence of new trading blocs and currency blocs as new alliances are forged. In such an environment, these alliances would be increasingly viewed as an acceptable alternative to addressing diplomatic disagreements.
Alternatives may emerge, but USD dominance is unlikely to change for the foreseeable future
In our opinion, recent chatter about the end of the USD’s role as the global reserve currency is misguided: The United States and the American greenback will continue to play a commanding role in the world economy.
It’s difficult to think of another currency that has the capacity to displace the USD—any serious contender would need to be supported by a market that’s at least a near equivalent to the U.S. financial market in terms of depth and liquidity. In addition, any country that would like to see its currency take the role of the global reserve currency will need to be able to run large trade deficits and steer clear of any meaningful form of capital control. These are the costs associated with being the world’s dominant currency for trade.
Top five most traded currencies by turnover (%)
Source: Bank for International Settlements Triennial Central Bank Survey, April 2022. As two currencies are involved in each transaction, the sum of shares in individual currencies will total 200%. USD refers to the U.S. dollar. EUR refers to the euro. JPY refers to the Japanese yen. GBP refers to pound sterling. CNY refers to the Chinese yuan.
It is true, however, that alternatives to the existing system are emerging. In our view, it’s a reflection of the gradual shift to a bifurcated global capital market: The internationalization of the Chinese yuan, for instance, is one to keep an eye on. Mainland China made significant progress in Brazil and the Middle East in the past year or so, building on the work it’s done through its massive Belt and Road Initiative. In an unrelated but equally eye-catching development, India reached an agreement with Malaysia recently to settle trade between both countries in the Indian rupee.
These shifts may be noteworthy but, for now, they only represent a mere fraction of the US$7.5 trillion a day over-the-counter foreign exchange market—as of April 2022, the USD is on 88% of all foreign exchange trades, a level that’s largely unchanged from 2019. What this tells us is that these currencies are unlikely to replace the USD as the global reserve currency anytime soon, and neither should they. Such a development in the near term would almost certainly be hugely disruptive and would, in our view, represent a shock to the global economy.
A more complex and volatile backdrop for investing
As is the case with death and taxes, change is a permanent fixture of life, and so it is with the global economy. The commonly accepted way of doing things—including trade and diplomacy—could soon give way to other forms of arrangement and, along with them, new rules of engagement. This, in our view, could make for a more complex and volatile backdrop for investing.
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