Appetite for renewed Fed dollar swap lines in doubt

As the New York Federal Reserve’s three-month US dollar swap lines come to an end over the next few weeks, traders are unsure whether they will be renewed.

The price of central bank swap lines was lowered after dealers’ dollar borrowing costs via foreign exchange swaps soared in March. But with FX swap prices normalising since then, it’s unclear whether banks will tap the lines again or hit the open market.

“It’s a bit of an unknown. But if the costs are as close as they are between the euro/dollar FX market and the Fed line, I would use the market instead,” says the head of short-dated G10 rates at a European bank.

In March, coronavirus-related concerns led to a dollar funding squeeze. To combat this, the New York Fed lowered the price on its US dollar swap lines with major central banks by 25 basis points on March 15 (see: How do the swap lines work?). The aim was to improve liquidity conditions by providing other central banks with the ability to deliver US dollar funding to their regional institutions.

Around $114 billion of these three-month swaps mature on June 11, roughly $30 billion from the Bank of Japan, $76 billion from the European Central Bank, $7.3 billion from the Bank of England and $315 million from the Swiss National Bank. In total, by the end of this month about $296 billion is set to mature.

The Fed charges 25bp over the three-month US overnight indexed swap rate – approximately 30bp all-in – as interest on the swap lines. As the funding crisis peaked in March, the cost of an FX swap, as measured by the difference between spot and the three-month FX forward points using the OIS rate as a benchmark, reached nearly 150bp all-in.

The price of FX swaps improved to around 20bp in mid-May, meaning it was possible for a eurozone bank to obtain dollar funding via the open FX swap market at a cheaper all-in cost if the price held. Traders at that time were already predicting a rise in FX swap costs as the swap line expiry drew nearer.

The FX swap price duly rose to around 32bp as of June 8, making the central bank swap lines more attractive from a price perspective. But while the swap lines might be cheaper at the moment, it remains unclear whether banks would want to tap them again, given the stigma in doing so.

“People don’t ever really want to use the central bank unless they have to. so if you can source the funds in the market at a price that’s similar to what’s on offer from the Fed, I think people will do that,” says the short-dated G10 rates head at the European bank.

If you can source the funds in the market at a price that’s similar to what’s on offer from the Fed, I think people will do that

Head of short-dated G10 rates at a European bank

On the other hand, some are concerned that the FX market might lack the liquidity to accommodate a switch en masse from central bank swap lines to the open market. If every market participant had the same idea of letting their central bank swaps roll off and moving to the FX swap market, some traders worry that prices could skyrocket.

However, the short-dated G10 rates head notes that the Fed’s swap lines, in effect, create a cap on how much market participants would have to pay for swaps. If the wholesale market price started to exceed 30bp, market participants could just utilise the Fed’s liquidity instead when it came time to roll.

He also says dealers that utilised the swap lines back in March are unlikely to seek the same amount of liquidity, as banks probably sourced more dollars than they actually needed in case market conditions worsened. This means the open market can probably handle the required flows.

“There won’t be a like-for-like need. If you’ve got $390 billion running off in the next few weeks, that doesn’t mean $390 billion needs to be replaced,” he says.

“They’re decent enough amounts that there would be some impact on the market, but I think there’s enough liquidity around now that people can raise funds in the market instead,” he adds.

An FX forwards head at a second European bank questions the need for dollar swaps in the first place, given the market is now out of the March danger zone. “If the maturities don’t get renewed with the Fed, it’s not because the market is going to supply those swaps instead. It’s because banks don’t need them.”

Similarly, Eric Donovan, head of FX and interest rates at INTL FCStone, says Japanese and European banks appear to have no desperate need for dollar swaps overall, so they could just let their swap lines with the Fed roll off.

“I don’t see anything to indicate that there’s a real underlying demand in Japan and Europe for dollars, so in my opinion these central banks can let those swaps naturally unwind as they have excess reserves to do so. There isn’t any underlying market economics that’s creating excess demand for dollars in those countries,” he says.

This article first appeared in sister title Risk.net.