While the attention of newspapers and news channels has been riveted on the massive sell-offs in equity markets, a much more serious crises has been underway. Systematic volatility has spiked to levels last seen at the peak of the global financial crisis.
Systematic volatility is a fair proxy for financial market-wide risk aversion. Even without any exogenous shock, such a shock to systematic volatility would result is a sharp contraction in the supply of dollar funding. Basically, the risk appetite of global banks works as a tidal force in global markets. When risk appetite is running high, the price of risk falls, ie asset prices rise across the board; the dollar weakens, emerging market currencies strengthen; money flows far into the riskier corners of the asset universe — from junk bonds, to crypocurrencies, to the frontier stock markets of sub-Saharan Africa et cetera. When risk appetite is low, the price of risk falls as asset prices rise, the dollar strengthens, EM currencies weaken; and the tidal flow of western money recedes from frontier assets. So when we see a spike as large as this, we should expect a sell-off of risk assets across the globe — in proportion to their exposure to global financial intermediation. This is what Hélène Rey has called the global financial cycle.
Of course, what is happening is not simply an endogenous shock to risk aversion. Global supply chains are getting disrupted as a physical consequence of measures to deal with the Corona pandemic. As Pozsar and Sweeny argued right before the worst of it got under away, global supply chains are ‘payment chains in reverse’. Widespread and large-scale physical disruptions thus have the potential to send a financial shock wave “uphill”, from the periphery back to the center — that is to say, in the opposite direction of the global financial cycle whipsaw. Since global trade is booked and settled largely in US dollars, global supply chains require an ample supply of dollar funding. Such a shock is thus likely to become visible in a global shortage of dollar funding. This has indeed obtained as promised.
FX swaps or cross-currency basis swaps are instruments for secured lending by borrowing in one currency and lending in another, with the FX risk fully-hedged. The price of this cross-currency lending is called the cross-currency basis. It directly captures the scarcity of dollar funding in the global financial system. The next figure displays the cross-currency basis for the yen/dollar and euro/dollar swaps.
The recent spikes are very sharp for both funding currencies. But they are considerably sharper for the yen. This is evidence that the supply chain disruption in East Asia, the center of the pandemic, is driving the dollar funding crisis. Pozsar and Sweeney called it right in real time.